[bl] trading rules that work, the 28 lessons every trader must master

TradingRules

that Work

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TradingRules

that WorkThe 28 Essential

Lessons Every

Trader Must Master

JASON ALAN JANKOVSKY

John Wiley & Sons, Inc.

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Copyright © 2007 by Jason Alan Jankovsky. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmittedin any form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the webat www.copyright.com. Requests to the Publisher for permission should be addressed to thePermissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030,(201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used theirbest efforts in preparing this book, they make no representations or warranties with respectto the accuracy or completeness of the contents of this book and specifically disclaim anyimplied warranties of merchantability or fitness for a particular purpose. No warranty maybe created or extended by sales representatives or written sales materials. The advice andstrategies contained herein may not be suitable for your situation. You should consult with aprofessional where appropriate. Neither the publisher nor author shall be liable for any lossof profit or any other commercial damages, including but not limited to special, incidental,consequential, or other damages.

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Library of Congress Cataloging-in-Publication Data:

Jankovsky, Jason Alan, 1961–Trading rules that work : the 28 essential lessons every trader must master /

Jason Alan Jankovsky.p. cm. — (Wiley trading series)

Includes bibliographical references and index.ISBN-13 978-0-471-79216-1 (cloth)ISBN-10 0-471-79216-0 (cloth)1. Speculation. 2. Investment analysis. 3. Futures. 4. Foreign exchange.

I. Title. I. Series.HG6015.J36 2007332.64—dc22

2006014076

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

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www.wiley.com

The fault, dear Brutus, is not in our stars,

but in ourselves, that we are underlings.

—William Shakespeare

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vii

Contents

Acknowledgments ix

Introduction xi

PART I Getting in the Game

RULE #1 Know Your Game 3

RULE #2 Have a Trading Plan 9

RULE #3 Think in Terms of Probabilities 15

RULE #4 Know Your Time Frame 23

PART II Cutting Losses

RULE #5 Define Your Risk 31

RULE #6 Always Place a Protective Stop 37

RULE #7 Your First Loss Is Your Best Loss 43

RULE #8 Never Add to a Loser 47

RULE #9 Don’t Overtrade 51

PART III Letting Profits Run

RULE #10 Keep Good Records and Review Them 59

RULE #11 Add to Your Winners 65

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RULE #12 Use Multiple Time Frames 71

RULE #13 Know Your Profit Objective 77

RULE #14 Don’t Second-Guess Your Winners 83

Part IV Trader Maxims

RULE #15 Know the Limits of Your Analysis 91

RULE #16 Trade with the Trend 97

RULE #17 Use Effective Money Management 105

RULE #18 Know Your Ratios 111

RULE #19 Know When to Take a Break 117

RULE #20 Don’t Trade the News 123

RULE #21 Don’t Take Tips 129

RULE #22 Withdraw Equity Regularly 133

RULE #23 Be a Contrarian 137

RULE #24 All Markets Are Bearish 143

RULE #25 Buy/Sell 50% Retracements 149

RULE #26 The Only Indicator You Need 155

RULE #27 Study Winning Traders 161

RULE #28 Be a Student of Yourself 167

Conclusion 173

Recommended Reading 179

About the Author 183

Index 185

viii CONTENTS

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ix

Acknowledgments

Special thanks to those helped me stay focused on completing thismanuscript on time: my editor, Kevin Cummins, who just let mework but reminded me that deadlines are part of the business; Emilie

Herman at Wiley for being so patient with my lack of computer skills andendless questions; the staff at Infinity Brokerage and ProEdgeFX, who al-lowed me to work after hours with company equipment to finish the manu-script; Jim Cagnina and Jim Mooney at Infinity, who encouraged Wiley tosign with me even though this was my first real publishing opportunity;and my family, who encouraged me to stay with it when the work seemedoverwhelming. Thank you all.

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xi

Introduction

My editor, Kevin Commins, and I were in the company conferenceroom having a discussion about new book ideas. He wanted topublish a quality book on trading rules and had seen the 50 rules

my company had published on its web site as a great starting point. Couldwe expand those basic ideas and produce a book on trading rules?

The owners were interested but really didn’t have the time to commit.I told Kevin that the reason so few good books on trading rules were outthere is because trading rules are more like guidelines and completely sub-jective; in my opinion most of the rules don’t work anyway because mosttraders don’t know how to use them. He was surprised to hear that pointof view, but he was open to seeing something different. We discussed theconcept a bit, and that became the basis for this book—answering thequestion, “Why don’t the rules work?”

I discovered that is not an easy question to answer. For the first fewmonths I had notes all over my home and office but nothing you could calla manuscript. After giving it substantial thought, I decided on a pathway ofsorts to offer the reader a fair answer to “Why don’t the rules work?”

At the core level, all the trading rules, guidelines, trader maxims, or in-sights are a factor of trader psychology and market psychology. The mar-kets provide the illusion of unlimited opportunity and complete freedomto pursue it; “rules” and behavior controls seem to be in opposition to thatidea. It is only after we as traders get beaten up by the markets for a periodof time do we begin to have the light go on. “Cut your losses” is not a rule,it is a point of view that leads to protecting yourself. But what exactly doesthat mean for me personally, and why do I need protection from myself?Why don’t I follow the rules?

In Edgar Allan Poe’s short story “The Purloined Letter,” he tells of athief who has outwitted the best efforts of the police to recover a stolendocument. As the story unfolds it becomes apparent to one of the outside

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observers that the letter must be hidden in plain sight; otherwise the po-lice would have found it by that time seeing as no effort was spared in ran-sacking the home of the thief, nor was it ever found by his direct arrestand search. Working from this hypothesis, this observer was able to re-trieve the stolen letter on his second visit to interview the thief; the letterwas indeed “hidden in plain sight.”

The rules of trading are much like that stolen letter. We often ac-cept the various rules that have been taught to us as traders, but thepsychology behind those rules is so inherently assumed that we over-look it. The psychology that really makes those rules work is often hid-den in plain sight. As traders, we all would agree that properly applyingthe rules will help us better achieve consistent trading success, and weall know from personal experience that breaking the rules has cost usmoney in the markets. None of us want to admit we break the rules(and some of us don’t even want to admit we need rules). So why don’twe follow the rules?

The purpose of this book is to outline the deeper psychology behindmost of the accepted trading rules and provide you, the individual trader,a better understanding of how to make your rules work. The rules are ac-tually guidelines grouped into four separate parts; the underlying, basicpsychology of each individual part is explored as each rule guideline isshown in proper context. As most traders know, there are literally unlim-ited ways of interpreting price action, choosing execution points, or for-mulating a hypothesis of general market conditions or potential priceaction. The intention is not to provide you with another trading system—God knows there are enough of those—but rather provide you a way ofshowing you two things to improve your trade approach: how you thinkand how the market thinks.

When you stop and realize that most traders have net losses, yet weall know the rules, what could possibly be the defining factor that sepa-rates the winning trader from the losing trader? I believe that there is noclear and definitive answer to that, other than one trader consistently fol-lows the rules he has adopted for himself and the other trader doesn’t; orworse yet has no rules. Because there is an unlimited number of ways toparticipate, I think the crucial issue is to find a way to personally applythe rules in a unique way that will work for you, and then do it all thetime. It’s easy to say “Cut your losses,” but every trader will have a dif-ferent way of defining that for themselves. The purpose of this book is tohelp you better define your personal trade approach by helping you in-terpret and apply the rules in a way that will work for your trading style.The rules are not the problem; it is making the rules work for you that isthe problem.

xii INTRODUCTION

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HOW THIS BOOK IS ORGANIZED

The first step is getting a firm grip on exactly what you are doing whenyou participate. Part I, “Getting in the Game,” outlines the psychology ofmarket price action, what that can only mean as far as your trade selec-tion is concerned, and how to begin from the point of a strong marketpresence. Trading is not as simple as “buy low–sell high” it is learning tounderstand the how and why behind price movement and how to partici-pate proactively without letting prices make your decision for you. Youmust buy weakness and sell strength to successfully trade, even if anothertrader would call that “picking tops or bottoms.” Your trade plan is a criti-cal part of developing a mind-set that uses prices rather than reacting tothem. Part of this process is learning to think in terms of probabilities, be-cause no trading approach can be 100% accurate 100% of the time; that isnot realistic for anyone. So Part I details what the game really is and howyou can better participate from a more unbiased point of view.

Part II is “Cutting Losses.” Every trader has had losses, and everytrader still participating every day will tell you how important cuttinglosses is for the long-term health of a trading account. In this section weexplore the underlying psychology of the rules of self-protection and whyit is so hard to enforce this much-needed protection for ourselves. Manytraders have a subconscious need to be “right” and will not liquidate a los-ing trade quickly. Even if you are not one of those traders, you will havesomething in your personal trade approach that makes it difficult to cutlosses quickly under certain conditions. Developing a set of personaltrade rules uniquely designed for your trading style will help you protectyourself—even when it is emotionally difficult to do so. Sooner or later,you will meet your Waterloo if you have failed to develop and enforcerules designed for your protection. Knowing when you are setting yourselfup for a loss, and what to do if you are already in the market when you dis-cover that fact, is a huge part of cutting losses. Sometimes your protectionstrategy will dictate that it is simply better not to trade. Having all theseoptions clear in your trade approach is half the battle.

Part III explores the opposite dynamic: “Letting Profits Run.” Everytrader at one time or another has liquidated a winning trade, only to seethat trade continue farther and farther in his favor. By applying a simplerule or two to remain in a winning trade, that trader might have taken ahuge win from the market. Letting a profit run involves different things foreach trader, but the underlying psychology is the same for everyone.Learning to develop an ever-expanding rule structure can help you holdyour winners until the market has run out of potential in your favor; andthat is rarely a function of price. Rather, it is related to the net order flow

Introduction xiii

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behind the price. Knowing when order flows are running out of potentialfor a winning trade is more important than the price at which it happens.Tracking this will involve multiple time frames, so a solid understandingof how those time frames are interrelated will help you write personalrules to maximize a winning trade.

Part IV is “Trading Maxims.” In Part IV we look at the some of themost common trading rules and how they have both negative and positivepsychological implications. Some of these rules will simply not work foryou personally, but because they make sense initially you might betempted to adopt them into your trade approach. This is frustrating at bestand self-destructive at worst. Some of these trade rules work best only un-der certain market conditions and should be used only under those condi-tions or not at all. The underlying problem with most of these rules is thatwhile they all sound good at first, they are often misunderstood in relationto time frames or the psychology of your personal trade approach. Some-times they are simply in conflict with your overall style.

For example, the trading rule “Buy the strongest member of the com-plex” is not a rule that would work well for a day trader. This rule wasoriginally used by position traders attempting to diversify across the un-derlying strength of something like the grain complex. Not knowing whichof the grains may advance farthest for the underlying bullish scenario,traders would buy all of them and leverage a little farther in the strongestpotential performer. In this case, anticipating a drought, they would buycorn, soybeans, and wheat but buy a bit more soybeans because soybeanstraditionally will move several dollars a bushel more during a droughtthan corn or wheat might. If you are not trading for the pull in the grainsunder those conditions, a modest correction in the soybeans will mostlikely take you out or cause a loss on the buy side, because soybeans havetraditionally been subject to extreme volatility, more so than corn orwheat. Buying the break for a day trade (in the strongest performer) couldeasily be the worst move possible for a day trader if that market went of-fer shortly after your entry. In that illustration, the trade rule doesn’t work.

I’m not suggesting that you refrain from using a rule that you findvaluable, but I think a solid understanding of what the rule was developedfor, how successful traders use it, and whether your time frame could useit as well is a great way to determine if you could make that rule work foryou personally.

In the final analysis, making the rules work is really about knowingyour personal psychology and your market’s psychology well enough thatyou do two things every day: Limit your potential to hurt yourself, andmaximize your market’s potential to pay you. Knowing the underlying psy-chology behind the rules will help, as well as personal study to apply themproperly. During the time of your trader development you will most likely

xiv INTRODUCTION

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come to the same conclusion most successful traders have: The rules areunique to each trader, but every trader follows the same guidelines. All ofthe various rules, insights, guidelines, and trader maxims work together todo two things: prevent the trader from hurting himself, and allow thetrader to get paid the most for his approach.

BEFORE YOU BEGIN

Before we get started, I would like to illustrate how this understandinghelped me improve my personal trade approach. As a young trader, Iwould often shoot from the hip—I would make a snap judgment based onmy point of view and execute instantly. Because I had no real rules for ex-ecution, I did my share of jumping the gun on trades that eventually wouldhave worked from that side, had I waited. Once I learned to follow Rule#10, “Keep good records and review them,” I discovered that I was oftencorrect on my initial observation about net price action, but being a day ortwo early (breaking Rule #4, “Know your time frame”) I was often stoppedout for a loss just before the market would turn. After this happened sev-eral times, I would simply execute again immediately at my stop price fora reentry, resulting in another small loss as my tighter but deeper stop waselected (breaking Rule #7, “Your first loss is your best loss”). This wouldhappen six or seven times (breaking Rule #9, “Don’t overtrade”) as themarket went a significant distance against my original execution; then themarket would turn. I would hold the winner but I would need to overcomea major loss to my equity before the trade had a net gain. On a 200-pointmove in Japanese yen, for example, I would net only 30 to 40 points be-cause I had a 150-point deficit to overcome first.

After reviewing my notes, my observations, and my execution history,I decided that my skill at observing a trade was not the issue. My timingwas usually a day or two early. I made a new rule for myself: “If I havethree losses in a row, I cannot trade for 24 hours.” If my first three at-tempts to buy what I felt was a sell-off were losers, usually I would get an-other chance right in the same area or better within a day or so. Bydisciplining my execution in this manner, I would save myself three orfour more losers, finally obeying the rules in Part II, and then I was oftenable to use the rules in Part III. Nothing really changed in my trade selec-tion or my analysis, but following the rules better allowed me to get intoposition better and stay there better. I learned to make the rules work forme personally. The money to be made was always there.

Introduction xv

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PART I

Getting in the Game

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3

RULE #1

KnowYour Game

The longest journey begins with the first step.

—Lao Tzu, in the Tao te Ching

Akey to making the rules work is an understanding of the psychol-ogy behind the rules, knowing where they work best, and know-ing if that is congruent with our personal trading style. The

psychology behind the rule is what it is, in part, because the psychologyof the market itself is what it is. I don’t think we can make our ruleswork at their best without a solid understanding of this underlying mar-ket psychology.

Critical to that assessment is understanding our own personal psy-chology. No matter where you personally are on the scale of trader evo-lution or your application of your developing skills, you will eventuallydiscover that your own personal psychology is by far the single most im-portant variable to your lasting success as a trader. Indeed, only a traderwho accepts this point of view about his own psychology will be able tosuccessfully make his trading rules work—because the rules are self-created, self-enforced, and self-defeating. Without a solid grasp of bothmarket psychology and personal psychology, your results will mostlikely be net losses, even if you have a winning systematic approach andgood rules.

Regardless of your current level of sophistication or trading back-ground, there is one indisputable fact about the underlying structure oftrading markets that you need to thoroughly understand before you placeyourself at risk. Futures, options on futures, and cash foreign exchange

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(FOREX), the markets most readers will be trading are all zero-sum mar-

kets. The price action and cash management take place in an environmentwhere no money is ever made or lost; gains or losses accrue as a cashdebit or credit between accounts on deposit after trades are cleared. Inother words, a winning trade is paid its cash credit from the exact oppo-site losing trade. The clearing corporation of the exchange simply assignsa cash credit to the account with the winning trade and assigns a cashdebit to the account with the losing trade.

In the final analysis, it is the losers who pay the winners. You cannotaccrue a cash credit increase in your trading account unless some othertrader (or group of traders) somewhere, trading through the same ex-change with you in the same market, has lost the exact same amount. Inorder for you to make $10,000 from your trading, someone else (or agroup of someone elses) had to lose $10,000. You can’t participate in zero-sum trading without accepting that risk.

It is the very nature of zero-sum transaction trading that makes usingand applying trade rules so critical to lasting success. If you personallydon’t know enough about what you are doing, or the risk you are reallytaking, you will be the loser who pays some other winning trader. Themarket does not function any other way.

Let’s take a look at the psychology behind price action. I believe this ismuch deeper than the simple fact that for every winning trade there is aloser. Zero-sum trading presents some fascinating insights into crowd be-havior and what is really needed or required to exploit price action prof-itably. Let’s start with the basics:

Buyer→ $2.33 ←Seller

You enter a buy order to open a position in corn at $2.33/BU. In orderfor you to receive a fill on your buy order, it must be matched against a sellorder at that price. For the sake of illustration, let’s assume there is also asell order to open a position. Therefore, two separate traders have putthemselves at risk, and a new long position and a new short position arenow active. What happens next?

Another set of orders comes in, and those are matched, but if at thatmoment there is an imbalance in the order flow, the market is requoted toreflect the imbalance. In other words, if there are more buy orders leftover after the sell orders are matched, the market ticks higher and ismatched with sell orders at higher prices, if they are there. The remainingbuy orders are then matched at that new higher price. If there are morebuy orders left over again, another tick higher results.

Of course, this illustration is conceptual. As most traders know, thosebuy and sell orders are constantly coming in and are combinations of stop

4 GETTING IN THE GAME


orders, limit orders, and market orders from both sides; the mix is alwayschanging. What we are concerned with is the pressure on the price as thenet order flow is processed from one moment to the next. If the order im-balance remains on the buy side, the market will continue to tick higheruntil the imbalance is corrected and the buy/sell orders are about evenlymatched again. If, at that point, the sell orders overwhelm the buy orders,the market will begin to tick lower and will continue to do so until the buyand sell orders again become about evenly balanced with the sell orders.The ebb and flow of price action comes from these order imbalances, andwhat we call an uptrend or downtrend is in reality a net imbalance lastingfor some period of time.

So let’s assume after a period of time, the net order imbalance for thatperiod of time has resulted in a new price for corn at that point:

→ $2.38/BU ←

Your open-trade long now has a profit of $0.05 per bushel. The openshort from your executed order (the other trader speculating) has anopen-trade loss of exactly the same $0.05 per bushel. If, at that exact mo-ment, both of you choose to liquidate your positions, and your orders off-set each other at that point, your account will be credited and his accountwill be debited the exact same dollar amount (less any fees, of course).

This is all easily understandable, but there is a completely other worldat work in that process. That other world is the psychology of the tradersinvolved and how that creates their urge to action resulting in them plac-ing the orders in the first place.

What is not immediately apparent in price action is perception—howthat net credit or debit is affecting the account holder, what that accountholder is thinking, and what he must do next. What is certain is that atsome point, both traders must liquidate; no one can stay in the market for-ever. When the losing position is liquidated at some point, the losingtrader must do an equal but opposite trade against himself. In otherwords, if I have bought the market, and prices are moving lower, I mustsell to liquidate my loss, adding power to the dominant force in control ofthe market at that point. My mental and emotional state is in direct con-flict with my desire for a profit, and my only choice really is to liquidatenow or risk a bigger loss. If I “wait it out” I am trying to anticipate themarket will reverse and eventually show a profit on the trade for me(thereby making a loser out of the original short who initially had theopen-trade profit).

But all of this thinking or emotion is going on inside my mind and hasnothing to do with what is driving the market. In order for prices to ad-vance or decline, there must be more orders on that side of the market.

Know Your Game 5


Prices can advance only if there are more buy orders than sell orders atthat moment. Prices can decline only if there are more sell orders thanbuy orders at that moment. How that order flow personally affects myaccount balance or my emotional state does not concern the net order-processing function of the market. In any attempt to profit from any per-ceived opportunity in a zero-sum transaction market, you simply must beon the right side of the eventual net order flow from that moment forwarduntil you liquidate. If you are on the wrong side of the net order flow, youwill have an open trade loss until you liquidate.

None of what happens inside the mind of the trader during that timecan affect the market in any way; it can only affect the net balance con-trolled in some way by the trader in some way. This is why you must haverules and know how to follow them. You cannot know for certain untillater, after you enter your position, whether you are on the right side ofthe net order flow.

The important thing to remember is that there is an emotional pres-sure at work in most traders that will influence their perception of priceaction. They all entered their trades expecting to win, but in most casesthey will have to consider liquidating at a loss. All of the emotional or psy-chological stress involved in trading boils down to “When do I get out?”Because the owner of the winning position has a lead on the market, he isunder less of this stress than the loser. In most cases, when the pain ofholding the losing hand gets too big for the losing trader, he will liquidatein the same direction as the winning position. A simple example is a mar-ket slowly advancing higher as more buy orders overwhelm the sell or-ders, until the market hits the liquidating buy stops above the marketplaced by the sellers who are holding a losing position. The market nowadvances further on that buying pressure.

None of the above-described background to price action has anythingto do with market study, risk control, trading systems, or technical analy-sis. It has to do only with the fact that if you are going to be in the market,you run the risk that you will be on the wrong side of the order flow. Whatdoes that do to the trader’s emotions? What will he do? What will you do?

Because you cannot profit consistently in a zero-sum market unlessyou are on the correct side of the order flow, your entire analysis andtrade plan must take into consideration some way to identify where theorder flow is and what to do if you are on the wrong side of it. The issue ofcutting losses is essentially to have some method of negating any emo-tional conflict created by a losing trade, in such a way that you will nothesitate to get out of the way of the actual order flow if you are on thewrong side of it. Part of how you participate on your trade, regardless ofyour unique approach to finding a trade opportunity, must always answerthe question: “Where is the order flow?”



Most of the studies done on net trader performance come to the in-escapable conclusion that around 90% of traders will close their accountsat a net loss. None of those traders expected to lose, and yet they did. Partof their losses came from the emotional conflict created in their mindswhen the market moved against them, creating pressure on their execu-tion. Every trader has had the frustration of finally throwing in the toweland liquidating his position, only to see the market reverse shortly there-after and prices move favorably, if only he had stayed in. All that reallyhappened is that the order flow dried up in one direction and then turnedthe other way. For that particular trader it resulted in a net loss to his ac-count. That particular trader will now be tempted to “just ride it out” onthe next trade until prices eventually return. Of course, the one time thisdoesn’t happen will result in a total loss in the account. It only takes one“just ride it out” to ruin that particular trader.

To avoid being that trader, and to master the game of successful spec-ulation, you must know what you are really capitalizing on when you iden-tify a trade opportunity. You must accept and trade from the point of view:“Where is the order flow?” and you must have a method of getting out ofthe way when you are not on the right side of the order flow. All the analy-sis or study you could ever do must answer these two central questions.

One assumption you can make to know your game is that mosttraders do not know the game they are playing. About 80 to 90% of priceaction is simply the losers liquidating their losing trades. When you begineach day, and before you place a trade, ask yourself this question: “Whereis the loser?”

In the final analysis, the game you are playing is “Beat the Loser.” Thegreat trader J. P. Morgan said it best: “Anyone who is unaware of the foolin the market probably is the fool.”

Know Your Game 7


9

RULE #2

Have aTrading Plan

If you fail to plan, you plan to fail.

—Old wisdom

Ihave had the privilege of seeing almost everything there is to see in thebusiness of trading. I have met some very well-known traders, bignames in business or finance; I’ve been on several trading floors, vis-

ited the trading pits numerous times, worked side-by-side with sometremendously successful market participants, and seen all the catastro-phes, mayhem, blowouts, and financial blunders capable of novicetraders. I have asked all the right questions and all the wrong questions. Inmy experience, I have to say that there was very little critical differencebetween the net winning traders and the net losing traders in most areas.All of them had good understanding of basic market fundamentals, used asolid technical analysis or research of some kind, and exercised a lot ofpersonal discipline.

The one thing that stood out, the one thing that separated the net win-ner from the net loser, all things being equal, was that the net winner had atrading plan in addition to his other skills. The net winner knew he was upagainst not just the market and his competitors, but he was up againsthimself, too. To guard against the possibility that he (the trader) couldblow himself out of the water at any time if he wasn’t careful, that traderhad a plan.

A trading plan is different from a trading system. A trading system isdesigned to find an inequality in the market and offer a better buy or sellentry than at some other time. A trading plan takes into account what


happens after that. Once we have identified what we think is an opportu-nity, it is how we participate from that point forward that makes all thedifference. A trading plan will address and complement a systemized ap-proach much better if it is seen as an equally important part of a strongmarket presence.

A trading plan addresses the parts of trading that are most fully inyour control. For example, when and where you do your market study oranalysis; when and where you place or move a stop-loss order; when youtake a trading break—basically anything that involves you taking action ornot taking action, independent of the actual market itself, is spelled out ina trading plan.

A trading system is only designed to exploit perceived inequalities inthe market, but it can never be 100% accurate or find exactly where everypotential “top” or “bottom” is in the time frame you are working with. If asystem could do that, no other discussion of rules would be needed. Onceyou have executed and placed yourself at risk, you have moved into thearea of your system’s probabilities and limitations. You as an individualcannot extend control over price action; you can only control how youuse price action or how you participate in price action. Once the trade istaken, the “die is cast” so to speak. Whether you win or lose at that pointis completely out of your control.

Because your system is not capable of finding each and every turnthere is to profit from in real time, a trading plan is needed to prevent youas a trader from getting reckless or from placing yourself in lower-proba-bility trades, and what to do when the unexpected happens. A trading planneeds to address your particular trading strengths and weaknesses; it inno way diminishes the need for a systemized methodology, nor is it de-signed to replace one.

Your trading plan can be followed 100% of the time because it is an ex-pression of the sum total of what your rules are designed to create; it con-trols your behavior, which is a function of discipline and willingness tofollow those rules. Your trading system may never be more than around55% predictive in finding winning trades, but you can follow your tradingplan’s rules 100% of the time. When your trading system is wrong, yourtrading plan will help you minimize the loss. When your trading system isright, your trading plan will help you maximize the gains.

A qualified trading plan is both concise and flexible. It adapts to mar-ket conditions as needed and is concerned with protecting the trader.You can think of a trading system as strategic and a trading plan as tacti-cal. To use a military illustration, “winning the war” is the goal, strategyinvolves finding the enemy’s weakness, and tactics are how you exploitthat weakness.



Think of your trading system or methodology as a strategic attempt toconsistently find a weakness in the market and exploit it. It really doesn’tmatter what it is; it simply needs to be consistent. Your trading plan ismore like the “if–then” tactical response to conditions as they change inreal time and as you learn more about a particular trade’s potential as itdevelops. Your trading system is designed to help you find the edge; yourtrading plan is designed to help you keep your edge or recognize whenyou don’t have it at a particular moment.

Your trading plan is where your rules are used to maximize your win-ning advantage when you have it and minimize your losses when youdon’t. What is never in question is that winning the war involves bothstrategy and tactics; sometimes tactics save the strategy, and sometimesthe strategy needs very little tactics. Knowing this balance is also impor-tant because, as we discuss later, all analysis of the markets will have astrategic advantage but also a strategic limitation. Your trading plan givesyou the tactical advantage of knowing which strategy will work best, un-der which conditions, and what is most likely to be your best initial moveto keep pushing your advantage into more and more profitable positions.The major goal is, of course, to cut losses and let profits run.

SO HOW DO I CREATE A SOUND TRADING PLAN?

Every trader must make several critical distinctions when creating asound trading plan. We discuss some of the more crucial aspects ingreater detail throughout each rule in the book but there are several ini-tial ones you can focus on to start creating your unique trading plan.Starting from the assumption that you can’t participate at all if you losetoo much of your trading capital, the first concern is how to minimizeyour participation when you are losing. This is different than cuttingyour losses. Cutting losses is part of your trading system and after youhave had a significant amount of those individual losses for you person-ally it is time to consider a few things. First, are you using the system ormethodology correctly? Part of your trading plan should be a regular re-assessment of whether you are fudging on the system in some way. Areyou taking trades the system wouldn’t take? Are you hesitating on tak-ing every signal? Are there some trades in there that you waited on andwere “late”?

A solid trading plan is a guideline to help you maintain focus. Yourfirst and best clue that you are not maintaining your best trading focus is aseries of losses that are outside the limits of the trading systems’ probabil-ities. At that point, you as the trader must decide what your rules are

Have a Trading Plan 11


when you are experiencing an irregular drawdown. Some of the betterthings to do include taking a step back and observing if the market itselfis operating in a manner that is no longer consistent with the trading sys-tem or method hypothesis. If you are using a trend-following strategy, sup-pose the market is no longer trending? A trend-following system will getchopped to pieces during a period of consolidation. What is your plan fora tactical change at such a time? Only you can answer that question com-pletely but the theme of your trading plan must consider a “what if” sce-nario for the outside chance that the quality of the market has changedenough to lower the probability of your system performing. Part of yourtrade plan is some method of standing aside.

There are times in every trader’s life when the worst possible thingthat trader could do is participate. Your trading plan should address thepossibility that outside life issues or pressures can influence your abilityto trade well. What can you do to protect yourself when your emotional ormental sharpness is potentially dropping? When you lose control of yourfocus, you run the risk of missing a critical piece of information about themarket structure at just the wrong point, creating a loss. Your trading planmust address your personal and emotional needs as well as the financialrisks you are taking. It might be a good idea to plan regular trading breaksfrom time to time, regardless of how you are doing in the markets. If youare planning a major life event such as getting married or sending one ofyour children off to college for the first time, your trading plan should ad-dress those needs in such a way that will prevent you from getting care-less. All traders at some point have had something throw them off, and ifthey continued trading at that point, in most cases that stress or pressureaffected them negatively as far as their trade selection and execution areconcerned.

Everyone has heard the stories of the lucky individual who won alarge amount of cash in a state lottery. Suddenly, without any advancewarning, some fortunate soul has several million dollars in cash. Beingcompletely unprepared for such an event, many of these people havemade serious financial mistakes with those monies and in the end, wereworse off financially than before they had won that money. Your tradeplan should also address how to participate best if you are doing well atsome point. A large degree of financial success can have a negative impacton a trader just as easily as large losses can.

To ensure your continued success it would be wise to adopt somemethod of reducing your participation until you have mentally and emo-tionally processed that success. There is a temptation to think that whatcreated your success and the size of that success can easily be duplicatedand will always be the state of your trading. This happens a lot to newtraders with little experience who, unbeknownst to them, were just lucky.



They make a large amount of cash by accident and confuse that with truetrading skill—or worse, think they have found the perfect system. If theyare not careful, their lack of skill will cause this trader to “give it all backplus more.” Additionally, this trader will not be sensitive to the possibilitythat the quality of the market has changed and his “system” is no longereffective, nor will he know when it might become effective again. Yourtrading plan should address what to do when you are far enough ahead tocreate a possible problem for yourself. In other words, what do you do ifyour money gets “bigger than your head”?

If you are thinking along these lines, you are beginning to draw theconclusion that all of the rules we discuss here, together as a group, arewhere your trade plan initially comes from. In the final analysis, your trad-ing plan is a reflection of your willingness to properly use the rules whenyou need controls on your behavior. Your rules can change and your trad-ing plan can continue to evolve, but your willingness to consider your sideof the ledger equally as important as your trading system is the key towriting an effective trade plan. Following is an example of what I wouldconsider to be a well-written trading plan.

My goal is to earn 100% on my trading equity before the end of the

year. To maintain my focus I will set a near-term goal every quarter

to be at a 25% gain and I will plot my equity daily. If I reach my

quarterly goal ahead of the last trading day of the quarter I will take

a two-day break. I will hold any open positions that are at a profit

but any open trade losses I will close at that point before I take a

break.

If my open-trade gains continue into the new quarter I will add

to those winning positions by a factor of 25%. I will move my pro-

tective stops up to reduce my exposure on the entire position.

If I am behind on my trade goal for the quarter, I will take a five-

day break. I will reevaluate my trade system and ask the question:

“Has my market quality changed to something in which my system

is not able to perform at its best?”

During the year I will not trade more than three markets. I have

learned I cannot focus well on more than three markets at a time.

If I have more than four losing trades in a row in any of my

three markets I will take a trading break for five days. Again, I will

leave open position winners alone in the other markets but close

all losing positions. I will again roll protective stops to reduce

my risk.

When I take a trading break, I will enter resting limit orders in

the open-trade winners to take the objective profit should I be un-

available and the market reaches those levels during my break.

Have a Trading Plan 13


If I am ahead of my plan for the year at any point I will take a

break. I will take 30% of the new equity out of my account and place

that into a secure place. If I am behind I will not add equity under

any circumstances. If I reach a 40% drawdown from my high equity

I will quit for the year.

I will record my daily trade activity in my trading log and re-

view this weekly. I will know my ratios and results; I will look to

improve them by 5% each quarter.

I will trade only from the bull side because my analysis tells me

that all three of the markets I have selected have more than a year of

solid bullish fundamentals. I will learn how to use options this year

because I see from last year I could have protected more trades if I

had a solid grasp of when to use options and when not to. I will in-

vest two hours a week on option knowledge.

My son is leaving for Europe in May. I will not trade the week

before he leaves or the week after. I plan to join him in the fall for

Oktoberfest for one week and will not trade the three days before I

leave or when I get back. I know I suffer from jet lag so the week af-

ter I am back I am not at my best. I have blocked out these times on

my trade calendar so I will not be tempted to trade anyway.

This was an actual trade plan written by a friend of mine who trades E-mini futures. He uses a simple technical approach and has a very thoroughrisk control method. His trading plan addresses the need for 100% personaldiscipline. Notice that it makes no mention of the technical approach heuses. The approach is his strategy. His plan specifies how to maximize hisside of the equation—the tactical advantage he personally needs.

When developing your own trading plan, remember that your system-ized methodology won’t have 100% winners no matter how you slice it.The one thing you always have 100% control over is your participation.Your trading plan should focus on your participation, not your execution.



15

RULE #3

Think in Termsof Probabilities

There is an ambush everywhere from the army of

accidents; therefore the rider of life runs with loos-

ened reins. . . .

—Hafiz

Because we live in a world where often certain things appear to becommonplace and “normal,” we have developed a greater feeling ofcertainty as it pertains to our daily lives. Human beings find a sense

of certainty in the belief that our day-to-day world is natural and is simplythe way things are. Some of us have grown so accustomed to this feelingthat we have a routine that actually bores us, and some of us go out of ourway to do something, anything, to break free of the grip of the ordinary inour lives.

Often when the unexpected happens, we feel that the odds are some-how changed, but this is usually seen as temporary. Often the truly ran-dom nature of things is not regularly apparent enough for us to see thatwhatever happened could have occurred at any time and that we are atrisk in that manner at all times every day. For example, because most peo-ple will be in a car wreck perhaps only once in their lives, the everydayrisk of driving seems to be very low. If we do have a car wreck, we con-sider it a “random” event that only seemed manifested to us “by accident.”We feel this way because normally we drive every day without incident.We have come to feel that it is more of a certainty that each day will passwithout the random event occurring to us personally. If it does occur, wethink it is a fluke.


The fact is, most people create the “accident” that they find them-selves in by failing to make the connection between their actions andwhat happens next. For example, most people who drink and drive don’tbelieve the problem was entirely theirs, yet it was their impaired judgmentthat increased the odds that the seemingly random event would happen tothem. Because they drive sober and without incident 95% of the time, theyfail to recognize that during the 5% of the time they are not sober, theprevious 95% success rate is now null and void. The rules of the gamehave changed. They are in an entirely different environment that bears noresemblance at all to the previous degree of certainty.

Our mistake is not so much in our perception of reality, but in un-derstanding the nature of how probabilities affect us all day, every day.There are very few things in life that involve certainty, and the fact thatsome things only happen to each of us individually maybe once in ourlives does not change the probability that they will happen every day tosomeone.

Indeed, the entire business of actuary analysis is an attempt to ana-lyze how best to spread the risk of an event that will happen across asmany people as possible to whom it might happen. Insurance companiesmake money by diluting the risk in this way, and they do best by writingpolicies to people to whom the event will almost certainly never happen.As an example, the reason active scuba divers pay much more in life in-surance premiums is that a certain percentage of scuba divers will drowneach year. If you don’t scuba-dive, your risk of accidental drowning islower; therefore your premiums are lower. But the fact is, someone willdrown this year, and the odds that are a regular percentage of those peo-ple will be scuba divers. Ask scuba divers what they think of that risk andall of them will most assuredly say, “Not me . . . I don’t do anything stupidwhen I dive.” Those divers have a sense of certainty that “drowning won’thappen to me.”

This issue of perception regarding certainties and probabilitieschanges completely when we begin trading. We leave the comfort of aworld that usually works a certain way and enter into a world where thetruly random and unexpected can happen at any time. The events are ran-dom and unexpected not because the market is indefinable or becauseprice action is somehow so mysterious as to defy explanation, but be-cause we as individual traders cannot possibly know everything about themarket at all times; therefore we have a percentage of risk that is certain.Reducing this risk is not about more study or more knowledge. Reducingthis risk is about knowing probabilities.

All attempts to profit from a trade are in reality a best guess regardingfuture price action. It really doesn’t matter what your methodology is or



which technical or fundamental approach you ultimately settle on as theright combination of risk/reward system right for you. Because the natureof trading markets involves risk and uncertainty, it is impossible to knowexactly how any one trade will eventually play out through price actionuntil it gets there. Markets are not definable past a certain point, and nomatter the depth or scope of pretrade analysis or research, there is alwaysthe possibility that prices won’t respond in the anticipated direction orwon’t respond in a time frame you are willing to trade in. Wall Street andLaSalle Street are full of traders who were right too soon, waited too long,got out too soon, got in too late, and so on. All of those kinds of results—whether this means small profits, no profits, small losses or big losses—are simply because whatever systematized approach was being reliedupon had reached its unique limit or the trader failed to appreciate thatlimit. They were all “best guesses,” and that means they don’t work 100%of the time to begin with.

Reducing your options to the best probability before you enter a tradeis a function of several things. First, if you have done a proper assessmentof general conditions according to your trade plan, there will be a pointwhere prices are more favorable for an entry and will respond by an ad-vance in the direction of conditions. Waiting for that point and then exe-cuting immediately is your best option, but where is that point?

When entering a trade we don’t have the benefit of knowing if ourexecution point was the best price area; we find out sometime later. Toimprove your odds of timing your entry better, develop a series of “if–then”scenarios and ask yourself which is more likely.

Let’s take an example from a potential bullish market condition. Wecould start with the hypothesis, “If conditions are bullish, and the tradingpopulation responds accordingly, then prices should rise.” I know thatsounds overly simplistic, but let’s look at the various psychological as-pects of such a simple statement and how that could play out in day-to-day price action.

If prices are at the moment still declining, this means either mosttraders don’t feel conditions are bullish just yet, shorts are still in controlof the market, or some combination of short-term and long-term marketplayers looking for an opportunity is such that so far the net order flow re-mains offers. Since in most cases the majority of traders will not see achange in conditions far enough in advance to buy into a declining mar-ket, nor will they hold a position for the time required to earn the largestgain from a change in trend, we can assume that the majority of tradersare either still short the falling market, on the sidelines waiting to make amove on the short side, or executing regularly from both sides with vari-ous results to their accounts. But as far as you are concerned, buying into

Think in Terms of Probabilities 17


a declining market has a degree of risk; hence the old favorite rule, “Don’tpick tops or bottoms.”

The absolute best place at the lowest risk for a trade is at the top orbottom, but finding that point is where the issue of probabilities comes in.If you knew the market had bottomed, and you were willing to assume therisk that conditions were turning bullish, you would want to execute atyour price right now. It is absolutely certain that sooner or later that mar-ket will bottom, but is the current bottom a bottom or the bottom? Nomatter your research or analysis, you cannot know that for certain untilsometime later, so you must think in terms of probabilities. Let’s look atan example, shown in Figure 3.1.

In this figure, prices are moving in a general sideways trend. Thismeans that buying and selling pressure is about equally balanced, becausea market cannot steadily advance or decline unless there are more ordersnet from one side or the other. At this point in time, both the profitableshorts and the potential longs are seeing two opposing things. For theprofitable short, his risk is increasing because no further net price action


FIGURE 3.1 Nearest Futures Contract, CBOT Corn for July Delivery, as of De-cember 2005


is favorable for additional profit; he must either cover or wait for the trendto resume. For the potential long, the lower the price goes the better theopportunity if the change in trend is coming eventually. The longer themarket does not go down, the better the potential that the actual bottomis finally in place.

In both cases, a choice to enter a buy order is the only result, nomatter when either side decides to do it. How those buy orders are nowbeing absorbed by early long liquidating with a sell order is a great clue.If the buy orders are mostly late (old) shorts liquidating, a drop in openinterest will result. The traders with the selling point of view are chang-ing their minds. Figure 3.2 shows this well. Note the steady advance incorn prices after high volume and a drop in open interest from that pointforward.

The study of volume and open interest (V/OI) is an entirely separateissue from the psychology of thinking in terms of probabilities. If youwere looking at a potential bullish scenario developing and you knew thatmost traders were bearish or prices were still declining, at some point you


FIGURE 3.2 Nearest Futures Contract, CBOT Corn for July Delivery, as of April 2006


knew that would change sooner or later because it is not reasonable toexpect corn prices to drop to zero; somewhere between zero and wherethey are now, there will be a bottom price. It is more likely that a bottomis forming when no one wants to sell the market anymore; it is too riskyfor an additional price decline as far as the shorts are concerned. The po-tential bulls see their risk dropping the farther the market goes lower,and at some point they will simply say “Wow! That market is on sale!” andbuy. If that scenario develops to the point where the buy orders (bothnew longs getting in and the old shorts getting out) compete with the sellorders (late shorts getting in and early longs getting out), and a drop inopen interest results, the probabilities are rising that a bottom is formingbecause the only trade group who is most at risk for a price rise would bethe open-trade winning shorts. The late short is dead meat anyway so hedoesn’t count.

When these two opposing points of view actually do something, youhave the potential of a bottom forming at that price area. The V/OI ratio isonly one clue. As a trader thinking in terms of probabilities, your onlyquestion is what is more likely to develop as time goes on. Sooner or laterthe market would have bottomed anyway. If you want to be on the rightside for the pull when the trend changes, you have to ask yourself whenand where it is most likely to happen, and that is not at any one price; it isa factor of the psychology behind the price.

The same psychology is behind every form of trade selection you do.You are looking for what is most likely, given your understanding of thebullish and bearish pressures that are playing out, as you understandthem. If your time frame is shorter or longer, there will still be a morelikely scenario that needs to be considered when you make your tradeanalysis. It needs to be considered as part of your trade plan because aflexible trade plan accounts for the possibility that something is changing.Your goal as a trader is to go with the path of least resistance, and that is afactor of probabilities, not analysis.

I have found that the best thing to do when I am looking for the truepotential of a trade is to argue the case from both sides. I ask open-endedquestions: Who is winning? Who is losing? What could make either sidequit? What will cause the bulls or bears to liquidate? What will causethem to commit themselves more fully? Then the big question: Which ismore likely?

By asking several kinds of questions designed not to form a certainabsolute conclusion but to uncover the market’s best probability forward,you as a trader have more options open to your trade selection process.As that trade selection process gets better and better defined over time,you will see that some trades are better for you personally than others. By



thinking in probabilities you reduce the potential to have a loss by not tak-ing low-probability trades, and you increase the potential to let profits runwhen you are in a high-probability trade. You can’t know for certain aheadof time, but you can see the likelihood of one situation developing betterthan another.

At that point, you take your position and wait.



23

RULE #4

Know YourTime Frame

There is no right way to do something wrong.

—Anonymous

No discussion of trading would be complete without some dia-logue regarding the issue of a trading time frame. There is a rela-tionship between you as a trader, your trading plan, your trading

methodology, and the amount of time all of these variables need to ei-ther confirm or deny that an opportunity for a profit exists. Not allmethods will work under all time frames and if you personally don’tknow your own decision-making process very well, you might betempted to work with a system that is not compatible with your naturaltime frame.

Everyone has a natural time frame in which they function best. By“natural time frame” I mean the amount of time required for you person-

ally to reach a conclusion and then act on it. You cannot participate inthe markets without reaching some sort of conclusion that prices aretoo high or too low relative to some other price that the market willeventually reach, assuming that your hypothesis is the right one. Afteryou reach that conclusion, you then act on it. Depending on your per-sonal temperament, your tolerance for risk, your previous success orfailure, your education, and so on, the amount of time you need person-

ally might vary, and this is what gives rise to the multitude of differenttrading approaches.

What is not immediately apparent to most traders is that what soundsgood or makes sense initially when trying to create a market presence


may not be compatible with their natural time frame. If this kind of con-flict develops, then following the rules of the system will be difficult, aswill trying to create a trading plan, because those things are not in har-mony with the unique person of the individual trader.

The first step in selecting a methodology that will be best for you andin learning to best apply the rules is to select a trading time frame compat-ible with your character. If you are someone who likes to think thingsthrough from many different angles and then sleep on it before making adecision, a longer time frame for trading might work better—perhapsweeks or months. If you are someone who can make fast decisions andthink on your feet, then a shorter time frame might be best for you. Mosttraders go through many different approaches and systems, not becausethey haven’t found the right system, but because they haven’t found theright system for them. In many cases, it is the issue of a compatible timeframe that is a major factor.

Most traders start out trading in shorter time frames and then gradu-ally expand to longer time frames. This is partly due to general inexperi-ence and partly due to fear. Because gains or losses can occur quicklyand sometimes appear to be random to new traders, a shorter timeframe is attractive because it limits the amount of initial stress a newtrader feels when he is learning to maintain or develop a market pres-ence. Some traders conclude that trading is a completely random eventand therefore they must trade a smaller time frame, such as minutes.Others feel that the markets must reflect actual supply and demand fun-damentals sooner or later, and they view day-to-day or intraday fluctua-tions as random noise; they focus on remaining on one side of themarket for months at a time.

If a trader selects a time frame too short to begin with, that trader typ-ically feels that things are moving too fast and they tend to have a lot ofhesitation at entry points, looking for confirmation before entering a posi-tion. Even a small correction can be frustrating because that was a lossthat happened too fast, and often the market will return to the entry pricequickly. If a trader selects a time frame too long for his temperament, theboredom of waiting for a trade to work over days or weeks will cause adesire to overtrade or try to force the market to pay him. The frustrationof watching equity inhale and exhale daily by several thousand dollars willcreate a fear of loss and typically liquidation before the best objective isreached, because it is just taking too long to get there.

If you personally are experiencing a high degree of emotional conflictwhen you trade at this point, you can do a lot to eliminate that pressure byconsidering whether you are trying to trade a time frame that you person-ally are not compatible with. Additionally, if you have a high degree of ex-



pectation that a trade should work by a certain amount of time, you mightbe using the wrong time frame for you. Both of these inner experiencesare good clues that you are not trading under your natural time frame.

FINDING CONGRUENCY IN YOUR TIME FRAME

Why do a natural time frame and a trading time frame need to be congru-ent? The simple answer is because that is how the market itself is struc-tured. Every individual trader is operating under a unique world of bias,assumption, expectation, and emotion. Not one of those traders enteredthe market expecting to lose; they all (including you) are expecting theirtrade to make money “right now” when they put themselves into themarket.

In order for that particular trade to either make money or lose money,a certain amount of time must pass—and every one of those traders canonly give that trade so much time. The time between the execution to getinto the market and the execution to exit the market is the actual timeframe the individual trader is operating under; but that is often not thetime frame he had planned on for himself.

Since most traders are experiencing losses, most traders feel a senseof attachment to their trades, and most traders are disappointed when anyone trade is a loss; most traders are exerting force on the market in a timeframe that is not what they intended. They all expected their trade towork “right now,” but if the concept of “right now” is not exactly clear,then the amount of time required for the trade to develop its true potentialis not clear. If the price action that is happening “right now” is not whatthe individual trader expected or intended, he loses control of his execu-tion because the price action in the market is influencing his willingnessto act. That trader is not choosing to make use of prices; the prices are us-ing him.

A simple illustration of this potential is a successful long-term traderholding a position for weeks against him. If, for example, this trader is ex-pecting a rise in prices, and he is willing to wait months for the potentialto develop, he might buy that market on a weekly time frame. He knowsthat it is usually impossible to pick the actual day or hour the market willmake the actual turn in price, but he also knows that when it does, he willbe positioned near the best area for a price advance. He might buy part ofhis position at that time and plan on buying more over a six-week periodof time. He may even buy part of his position at an actual lower price thanhis first execution because he is confident enough in his analysis and his

Know Your Time Frame 25


trade plan to trust himself with that particular use of his capital. He mighthave committed himself to holding the position, no matter what, until aparticular date forward because if it isn’t happening by then, the potentialin the trade is dropping. For this particular trader, on this time frame,what happens the day after his initial purchase is unimportant; he mightsee that as random noise. That particular trader’s concept of the tradeworking “right now” is six weeks long.

Now consider a bearish trader in the exact same market. He might belooking at a weekly high as a selling opportunity, but he is using an hourlytime frame and has no intention of holding any trade over a weekend. Af-ter that market trades to a weekly high, he might wait six hours for a con-firmation that the high is in for the week. He then executes on the sellside, and if that trade is not working by the end of the day he will liqui-date. This trader’s time frame for “right now” is two hours. Additionally, ifthe trade is profitable he will exit the market within a very short timeframe—by the weekend.

In both cases, no matter what time frame each trader is executing un-der, sooner or later the net order flow will affect their positions. In onecase, weeks are needed for the corresponding pressure on the trader’sthinking to develop; in the other case, only a few hours. The eventualprice that market ends up at during the next three months probably won’tmatter to the hourly time frame trader; he will have had many opportuni-ties as he would define them during that time. The weekly time frametrader might see things entirely different. Yet both traders are executing inthe same market, and both traders exert pressure on price action by theirexecution.

WHICH TRADER ARE YOU?

Knowing your personal time frame is a necessary part of your trade ap-proach because the only thing that will pay you a profit is getting on theright side of the order flow for that time frame. If you are an hourlytrader, it is not wise to position yourself on the opposite side of theweekly trader. His order flow takes longer to develop, and he will not exe-cute on the other side of the market until a much larger price swing hasoccurred. If you are selling against a weekly trader who is buying, he iswilling to hold that trade much longer, whether the market moves for himor against him. He won’t be there to sell off his unprofitable longs in thetime frame you are looking to buy back a profitable short. Your $200-per-contract open-trade short is random noise to him. Consequently, if yourtrade is not working in a few hours and you want to liquidate your loser,



he also won’t be there to liquidate his open-trade profitable long—he in-tends to hold it for months.

Of course, this is an over-simplification of price action, and in anyliquid market there will be plenty of orders available on either side. Butthe point is this: Different time frames are competing, and the intentionof one time frame is not always the intention of another. Your besttrades occur when your own time frame is the same as the time framecurrently in control of the market at that point. When that changes, yourtrade is over.

Part of developing a sound trading plan and a strong market pres-ence depends in part on knowing how to get positioned on the orderflow as it develops for a particular time frame. To do this, you mustknow what your time frame is before you begin trading. If you are notwilling to hold positions past a certain amount of time, your system ormethodology must be compatible for that time frame. Don’t buy a trend-following approach if you aren’t going to stay in the market long enoughto get paid from that trend; instead, maybe you should consider a volatil-ity approach, one that will give a signal for liquidation in a shorter pe-riod of time.

A good rule of thumb is that your time frame should reflect your will-ingness to hold a winner, not your tolerance for risk. All systemized ap-proaches or methodology must have an effective way to cut a loss quickly,but the ability to hold the winner is a factor of your time frame. If yourtime frame is daily, how many days could that trade have potential? Onceyou understand your personal time frame you can better hold your posi-tions because all time frames have a period of time that they need to fullyexpress their potential. Quite possibly that amount of time might be verysimilar to your natural tendency to allow things to develop for you, underyour personal natural time frame.

To help determine that ideal amount of time, I have found that a factorof three seems to work best. If you execute on a weekly time frame, youcould expect your trade’s full potential to take around three weeks to de-velop, assuming you are seeing it right to begin with. If you are a 15-minute trader, expect your trade to need 45 minutes or so to develop. Ofcourse, any one trade could have significantly more potential than yourparticular time frame will uncover, but that isn’t really the issue. No mat-ter what your time frame is, in every trade those probabilities drop aftersome period; how far that trade goes beyond your objective is an issue ofusing multiple time frames (see Rule #12).

But in all cases, whichever time frame you choose to use for yourmethod, ask yourself if that method and time frame are something youare naturally comfortable with. If you don’t like making snap decisions,then a short-time-frame approach offering several potential trades every

Know Your Time Frame 27


day will probably not work well for you. If you can’t stand waitingaround for things to happen, then a methodology that requires months(such as a system heavily biased to the underlying fundamentals) maynot be a good fit.

The important thing to remember when you select your time frame isthat cutting losses is only part of it. Sooner or later you will get on theright side of the order flow, and when you are you need to know that it isokay to give that trade the full amount of time it needs to develop the ac-tual potential it has. Your time frame is a significant part of that.



PART II

Cutting Losses


31

RULE #5

DefineYour Risk

Not risking is the surest way of losing. If you do

not risk, risk eventually comes to you. There is

simply no way to avoid taking a risk. If a person

postpones taking risks, the time eventually

comes when he will either be forced to accept a

situation that he does not like or to take a risk

unprepared.

—David Viscott, M.D., Commodity Trader’s Almanac, 1989

It is my opinion that the single most important skill to develop as atrader is the dispassionate ability to cut losses. How you conclude isthe best way for you personally is less important than having a way to

do it and doing it all the time. Of all the trading traps that have to beavoided, the one trap that will cripple any trader the quickest is the inabil-ity to know and admit when the trade hypothesis is simply not workingnor may it ever work. This goes much farther and deeper than “admitting Iwas wrong,” believing “I can afford to wait a little before I decide what todo,” “taking necessary heat until this turns around,” or any number ofways of doing the same thing: justifying your inaction in the face of yourequity evaporating.

The only reason a losing trade happens is because at that precise mo-

ment you are on the wrong side of the order flow. It really doesn’t matterhow that happened or what you told yourself in order to execute at that


point; the fact is you are losing money. As long as you continue to remainon the wrong side of the order flow your loss will continue to grow, untileither you are forced to liquidate (margin call or worse) or you choose toliquidate when the pain of the loss affects you so greatly you can’t bear itanymore. In all cases of a loss being large and unbearable, the simple actof liquidating is done when the trader has lost control of his execution.Someone or something else—either the exchange, the broker, the marginclerk, or your personal need to avoid pain (emotion)—controls the net re-sult now sitting in the trading account. The worst losses will always occurwhen you lose control of your liquidating execution.

This loss of control over your own money is not a trading issue. It is asymptom of a deeper problem that at its root cause is a factor of thetrader’s personal psychology. No matter what the root issue is, the poten-tial for that root issue to take away your money must be adequately ad-dressed and prepared for. Sooner or later you as a trader will break theone rule you simply cannot trade successfully without: Define your risk.If you trade without defining your risk of loss, it is only a matter of timebefore you find yourself in a trading situation you were unprepared forand money is leaving your account at a hypersonic pace. To avoid thatpotential you must master this most important rule of trading: Defineyour risk.

What does it mean to define your risk? In my view, it is not as simple asmerely entering a protective stop order, although that goes without saying(I address stops in Rule #6). Defining your risk is a factor of your personal-ity and your personal skill set. Defining your risk should include not justthe cash dollar risk on each and every trade but should also be consideredas part of your overall market presence and willingness to participate.

Not every trader is a good fit for all market conditions or even allmarket opportunities. As an example, just because you own a gas stationand are intimately involved with the purchase and sale of gasoline everyday does not mean that you would instantly understand all the importantrequirements for successfully trading in Harbor Unleaded Gasoline Fu-tures (HU) at the New York Mercantile Exchange (NYMEX). Nor wouldyou immediately comprehend HU’s unique relationship to crude oil sim-ply because you have read a brief discussion of the “crack spread” or at-tended a one-day seminar on “Using Candlestick Analysis in the EnergyComplex.” Many traders make the mistake of assuming that a general un-derstanding of their personal business can provide them an adequate be-ginning edge to exploiting price action. Nothing could be further from thetruth. In fact, the exact opposite is often the case, usually because thetrader makes the assumption that his business knowledge is transferableto trading and therefore does not understand why his knowledge is nothelping his trading.

32 CUTTING LOSSES


One question you should ask when defining your risk is “How muchdo I really know about the _____ market?” If your honest answer is “Noth-ing, really,” then it would be a very good idea to commit to learning a basicunderstanding of what traders in that particular market focus on and whattends to cause a reaction in prices. As an example, many traders are sur-prised to learn that the Producer Price Index (PPI) and Consumer PriceIndex (CPI) reports are often largely ignored by professional FOREXtraders but are closely watched by interest rate traders, even though thetwo markets are intimately related on many levels. Without that knowl-edge, a novice trader might be tempted to execute a FOREX trade basinghis choice on something the FOREX market hasn’t considered tremen-dously valuable at this time, thereby assuming a potential risk that hewouldn’t have had otherwise.

As a trader looking for the best market presence you can master, it iswise to consider your actual education process as part of your risk-reduc-ing strategy. Can you honestly say that you are an expert on the marketyou trade? If not, part of knowing your risk might be to take a regular re-fresher course on market basics for the markets you trade. All marketsevolve and change over time. What worked last year may not work thisyear. Be prepared to regularly review and supplement your market knowl-edge, because often the best way to define your risk is to know in advancewhere the potential pitfalls might be.

Additionally, defining risk can include an assessment of your personalfinancial condition and where that adds pressure to your life. This is dif-ferent than the maxim, “Only trade with money you can afford to lose.” Ifyou are recovering from a divorce, for example, and have a strong need torecover financially, those non-market-related emotional pressures or con-flicts might easily spill over into your trade execution for reasons thathave nothing to do with actual trade potential. Someone who thinks hecan make his house payment from trading and expects to make thatmoney from the market in a short period of time may be placing himself ina worse position should he have even a small loss. Those types of risk canbe very real and should be carefully considered along with the actual dol-lar risk you take when you establish a new position.

How does your spouse or significant other feel about your desire totrade? If your spouse thinks you are nuts for trading soybean futures,maybe you don’t plan to tell your spouse you are losing until it is tax timeand you have a brand-new deduction to discuss. Imagine the pressure onyour relationship at that time. Maybe it would be a good idea for you toconsider the input your spouse may have. Many traders have discoveredthat the critical component to their trading has been a sense of confidencethat they are supported by their spouse. Some traders find sharing thewealth they have earned from the markets with their families has given

Define Your Risk 33


them a better sense of achievement. But the essential element that is oftenoverlooked by many traders is that their day-to-day relationship with theirspouse can be both positively and negatively affected when the family fi-nances are in question one way or the other. Having your spouse’s full sup-port will help you define your risk better if you are one of those traderswho might have your focus broken by conflict in the home.

One thing you can count on: Certain times in a person’s life make oneless available for the strong emotional and personal focus required to suc-cessfully speculate. Be sensitive to the personal side of your trading andconsider that there might be times when you will just not be at your best;those are the times to either stand aside or reduce your trade size for a pe-riod of time.

Once we have done enough of the right homework for the market wewant to trade, and we have assessed our personal pressures enough toknow we won’t be negatively affected by them, we are ready to address theissue of the financial risks inherent in every market. The fact is, we couldbe wrong on our next trade and we might have to accept a cash dollar loss.No successful net winning trader has 100% winning trades. There is a ten-dency for some traders to subconsciously expect each individual trade tobe the home run; otherwise, why are we in? Often it is this very expecta-tion that causes us to make the mistake of not defining what dollar loss weare prepared to take in the event the trade is a loser. After all, why place astop or select a getting-out point if this trade is the home run?

Many traders who have suffered larger-than-intended losses havelooked back on how that happened and said, “Yes, I could have gotten outsooner but . . . (enter stupid reason here).” The unwillingness to define therisk ahead of time put them in a position where they had no plan in placeto protect themselves; they lost control of their execution and now wereat the mercy of the market. Instead of ruthlessly cutting the loss at a pre-defined point, they did something else. They hoped, prayed, waited, etc.and the end result is that the market kept marking their account lower un-til they had no choice.

In the final analysis, defining our risk is a method to cut our losses,simply because we refrain from putting ourselves at risk until we have ad-dressed all the potential ways we could lose money to begin with. We arenot going to let anything take money away from us if we can avoid it. Wehave put things in place to protect ourselves. Sometimes that is an orderplaced in the market; sometimes it means going back to school to learn amissing skill; sometimes it means admitting we are not emotionally readyto trade, for reasons that we have to get straight first.

Lastly, your actual cash balance on deposit with your broker needs tobe money that is completely unencumbered for you personally. This needsto be an amount you can emotionally walk away from. Again, this is not as

34 CUTTING LOSSES


simple as “Only trade with money you can afford to lose.” In fact, the ex-act opposite is a factor that most traders miss until it is too late. If youneed those funds for any reason under any potential time frame, you run arisk of cutting your profits short. If you need your starting balance safelyback home in, say, six months, suppose you enter a strong position withreal potential at the five-month mark? Perhaps that trade might need an-other four months to develop its full upside potential, and maybe thattrade is the big mover in the market this year. Nothing will break a trader’sheart faster than having to liquidate a small winner that would have be-come a huge winner, for the sole reason that those funds are needed for adifferent purpose and he knew that going in.

Whatever funds you choose to work with, make certain that your riskon those funds includes not needing them later if you can avoid it. If, for in-stance, you know you will need a certain amount of cash for home repairsin the spring, ask yourself if the money you are depositing in the fall withyour broker is intended to be that home repair money. Not only do you risknot getting the repairs done if you have some losses, but if you are on theright side of the big trade for this year, you risk not getting your full benefitif you have to liquidate early for the sake of that pending obligation.

Because there are unlimited ways to lose money once you haveplaced yourself at risk in a trade, defining your risk incorporates as manyof those variables as possible and involves creating as many safety nets asyou can. Make this rule work for you by considering the possibility thatyour personal risk involves something in your life other than your cashtrading balance.

Define Your Risk 35


37

RULE #6

Always Place aProtective Stop

I shall tell you a great secret, my friend. Do not

wait for the last judgment, it takes place every

day.

—Albert Camus

Probably the single most misunderstood rule in the trading game isthe rule regarding the use of predetermined exit points, or, as it iscommonly stated in the industry, “placing a stop-loss order.” Most

traders use stop-loss orders ineffectively at best. The most often heardcomplaint is that liquidating stops are elected right before the marketcontinues farther in the intended direction of the original working tradeafter only a small correction. Many traders have experienced frustration,anger, or just plain disappointment when a trade that had real potentialfor gains was stopped out early. However, the issue appears to be morecentered on the proper use of stop-loss orders, not the question ofwhether they should be used. It only takes one unexpected adverseprice move to teach any trader the value of stop-loss orders. It seemseveryone wants the protection of stops but genuinely hopes they arenever elected.

Without a doubt, there is a tremendous amount of argument andopinion as to what exactly is the best use of stop-loss orders and whentrades should be protected. The only part of this debate on which allsuccessful traders agree is that this is the one rule that simply cannotbe ignored. Consistently placing and using stop-loss orders on your


open positions is your first and best defense against an excessive or un-intended loss.

When we first started our discussion of trading rules that work, Imade the observation that you cannot consistently trade for profits unlessyou are on the proper side of the eventual order flow. If you have doneyour homework and your trade hypothesis turns out to be the correct onefor the time in question, the order flow will show up on that side, and untilit changes, you are accumulating an open-trade profit. We are concernedwith the net order flow, not the temporary imbalances that create the ebband flow of price action on the tick-by-tick basis.

Understanding the net order flow and the potential that the trade maydevelop is a factor of understanding multiple time frames. I discuss multipletime frames in detail later (see Rule #12), but for the sake of understand-ing the psychology of using stop-loss orders let’s make an assumption:Order flow is never perfectly balanced on any one price tick, no matterhow many time frames are involved. There will always be at least one left-over buy or sell order at every traded price tick. Therefore, the marketwill always be subject to a temporary imbalance on some time frame thatwill cause prices to flow back and forth many times as that leftover orderflow creates the need for the bid or offer to be adjusted.

This knowledge instills the confidence that as long as prices are mov-ing in a general direction over time, we can hold that open position untilthe full potential develops as we see it. The market might ebb and flow be-tween two price levels for a period of time until it breaks out and reachesour objective, but we can recognize this as “consolidating” or “conges-tion.” The basic price action is not significant enough for us to liquidatethe open trade yet; that price action is normal on the way to the eventualobjective. We know that markets don’t go straight up or straight down;they zigzag back and forth on the way to a particular level—so sittingthrough that zigzagging action is our goal—except when that supposedlynormal zigzag in prices is a full-blown 61.8% retracement covering fourweeks of time and 7% of contract price value.

Now we have the issue of placing stops and what to do with them.How do we muster the confidence to hold a position through normal, ex-pected, and healthy price action on the way to our eventual goal? How dowe maintain the winning position without getting stopped out on a typicalretracement? I think the answer lies in how you define the purpose ofstop-loss orders and in understanding what it means to experience the un-expected—which will happen to every trader sooner or later anyway.

I take the point of view that stop-loss orders are not used to protectan open-trade profit. They are not a risk control tool. Stop-loss orders areprofit management tools and should not be used to liquidate winningtrades. They should be used to liquidate a position—any position—when

38 CUTTING LOSSES


something has changed with the underlying structure of the market, andnot before.

If you follow this thinking to its logical conclusion, that your winningtrade is happening only because you are on the right side of the net orderflow at that moment, then the best time to liquidate that winning trade willbe only at the point when the net order flow in that direction is about over.In other words, you have bought low and sold high for the maximum po-tential before the net order flow reverses. If you have called it right thenthe fact is that your protective stop-loss order was never in question—themarket had no potential in the direction against you, and you were prop-erly positioned for that order flow. Therefore, the stop was not elected. Infact, you could almost go so far as to say that if the stop order was neverplaced, the result would have been exactly the same because the fact ofthe order flow was what it was. This is why some people are tempted totrade without stops—but that is a different issue.

MOVABLE STOPS

Why then would you move your stop?I think that is the critical issue of properly using stop-loss orders. If

you have properly identified the net order flow, the stop is not needed andmight as well not be there. All the little price ticks in all those tiny littleswitchbacks or corrections are not the issue; the issue is whether the netorder flow has changed. You would only move your stop-loss order if youare not certain that you have identified where the order flow has run outof potential. You place your original stop-loss order only to protect your-self in the event that you have not properly identified the initial placewhere the order flow will change; if you are incorrect in your entry, youhave limited your loss to a predetermined amount according to your sys-tem methodology and trade plan.

If you are correct in your assessment, then there is nothing to do butwait until the net order flow runs out of potential in that direction. If youare uncertain of that point, then the movement of the stop closer to thetraded prices is your only option. And that brings us to the point of subse-quent stop-loss order placement after the market has begun to show youan open-trade profit. It is the psychology of moving this stop-loss orderthat is the central issue of properly using stops, because they are notneeded if your first hypothesis is the correct one, unless something haschanged and you missed it.

Your only question as it regards moving a stop-loss order closer to themarket prices after your winning trade begins working is “What if something

Always Place a Protective Stop 39


changes before I see it change?” There is no other reason to move a stop. Atthe very least, your trade plan should have some kind of rule that allows youto roll your stop-loss order up to your entry price on open-trade winners,thereby assuming a no-risk trade.

If you intend to use stop-loss orders effectively, you need to use themas a worst-case exit order only. Your first worst-case scenario is being inthe market on the wrong side of the order flow at the moment of initial en-try. The next-worst case is that the order flow runs out before you have areasonable lead on the market. The third-worst case is if somethingchanges and you didn’t see it coming fast enough to liquidate with whatthe trade had in it at that point. Otherwise, the only thing to do is wait foryour objective.

In my view, rolling stops aggressively to lock in profits is the surestway to cut profits short. Regular ebb and flow in the small order imbal-ance, regular retracements from significant highs or lows, and randomnoise between highs and lows are part of the game. It is unlikely that youor any trader will be keen enough on your observation that you will accu-rately call the near-term price points for such price action. Placing yourstops too close to the market is an expression of uncertainty and fear, ofattachment to a particular price instead of waiting patiently for the net or-der flow to run out in that direction. By rolling your stops aggressively yourun the risk of having your stops elected by the minor tick-by-tick orderimbalance. To avoid this potential, you need to see stops as the method ofliquidating only if something has changed. If nothing has changed with thestructure of the market, why would you increase your risk by moving astop-loss order?

One way to make the issue of placing stop-loss orders work for yourparticular trade approach is to move the stops for only two reasons. Thefirst reason is to take you out at a predetermined dollar loss or gainamount as defined by your risk management rules. In other words, if thetrade is working up to a certain amount of open-trade profit, you moveyour order to secure either a smaller loss/break-even amount or a smallprofit. After that point, the stop should not be moved until your objectiveis reached.

The second reason to move a stop would be if you are pyramidingopen trade positions. It would be advisable to always have a break-evenexit stop on your entire position in case something changes and the pyra-mid begins working against you, and the open trade position falls belowyour starting equity on the trade.

In all other cases, moving your stops aggressively is a dangerous andunnecessary method of increasing your risk of cutting a profit short. Oncea trade has given you a reasonable lead, you can make the near-term as-sessment that your hypothesis is the correct one. And once that trade is

40 CUTTING LOSSES


protected for little or no risk, moving a stop-loss order closer to themarket on a regular basis will only put you in the position of gettingcaught in the random minor tick-by-tick action that you have no need tobe concerned with anyway. If something has changed, and you don’t seeit fast enough to keep most of the open-trade profit from evaporating,why would you want to be in a market that you don’t see right in thefirst place?

Always remember that stops are not risk management tools. They areprofit management tools. They can only be considered risk managementtools if something has changed and you are on the wrong side of the orderflow by accident; in which case you would act in your best interest by liq-uidating anyway—except it happened faster than you could see at yourcurrent skill level.

In any case, your equity is protected and you can now look for the nexttrade with a clear head. Judgment day is every day, so place stops properly.

Always Place a Protective Stop 41


43

RULE #7

Your First LossIs Your Best Loss

Great opportunities come to all, but many do not

know they have met them. The only preparation to

take advantage of them is simple fidelity to watch

what each day brings.

—Albert Dunning

T raders who have a strong personality or high intellectual capacityare often found to be breaking this rule consistently. These tradersare often able to call tops and bottoms ahead of major market

moves for very concise and accurate reasons. They also tend to executeearly on those potential trades and suffer losses before eventually get-ting on the right side. Their belief in and commitment to their hypothe-sis is so strong that they continually execute from the side they feel isgoing to be the big move. Some of these traders have been right in theirhypothesis so early and continued to trade from the wrong side for solong that their account has lost significant equity getting to that point.Then when the big move comes, it is really only an opportunity to getback to even.

A bull market can stop being a bull market long before prices top; abear market can stop being a bear market long before prices bottom. Inreality, this is what these traders are usually seeing. They are looking farenough ahead to see a greater potential in the other direction and theyknow that the turn is coming. They may even spend long hours in analysislooking for that time/price relationship and take quality positions that


have an initial small gain; but then the market continues sharply in theoriginal direction and they are taken out. This type of trade situation givesrise to the outdated rule, “Don’t pick tops and bottoms,” but the fact isthat sooner or later a market must top or bottom; the lowest risk andhighest profit potential are always at the turns.

Identifying those turns is a completely separate issue, and I don’t evenaddress it in this book. It is my belief that in today’s market climate thetools and knowledge needed to find major turning points are availableeverywhere. The problem is not in identifying the turns; the problem is be-ing early.

The psychology behind this rule is the issue of nonattachment. Manytraders have not developed the underlying ability to adequately detachfrom price action emotionally. If we have a strong understanding of themarket we trade, and we feel very certain in our approach, and we can-not profit unless we buy low and sell high, at some point all of our knowl-edge and preparation pressures us into an urge for action. We concludethat “the time is now,” and we execute. Because we have invested somuch of ourselves in forming that conclusion, we have a subconsciousattachment to that trade. What we really have is an attachment to that ex-ecuted price.

When we have formed some kind of attachment to a particular price itis a small step in our thinking that something is “wrong” if prices do notadvance favorably in a reasonable amount of time. Having an attachmentto pricing is the problem, because prices do not move unless there is or-der flow on that side. If the price you personally select is not reasonablyclose to where the order flow is, that trade will simply not work from thatparticular price at that particular time. It might eventually, and the timefor that might be sooner rather than later, but in the meantime nothing iswrong. The market hypothesis that you currently hold might be the exactfuture that market has in store, but at this particular price/time relation-ship, you are on the losing side and you simply must stand aside. How youfeel about that trade, your knowledge, and your commitment to being inthe market have nothing to do with what is actually happening.

By accepting the first loss, you remove yourself from the equation.Notice that I said “accepting the loss.” The problem at this moment is not

within the market. The problem is with the trader and the attachment tothe trade hypothesis. The more educated, experienced, or successful anytrader becomes, the more susceptible that trader is to trade attachment,especially if he has previously taken a lot of money from that particularmarket previously.

Developing the ability to remain unattached to your trade results isthe issue behind making this rule work for you. No one trader will mostlikely call a turn in the market at the exact day and time it actually occurs.

44 CUTTING LOSSES


Most likely you will be near the price and time that a turn in the markethas happened for your time frame and your method. Most likely you willalways have slightly more losing trades than winning trades over time. Be-ing emotionally attached or strongly committed to any one price area, anyone trade, or one particular side creates an inability to reconsider your hy-pothesis. Perhaps you are 100% correct about the eventual path that mar-ket will take but at this particular moment you are on the losing side ofthe order flow. Don’t argue with it; take a new look at it.

Making this rule work for you is a function of both self-awareness andyour methodology. When we create a methodology for trade selection weare attempting to find and exploit an edge in the market. Self-awareness isa completely different part of the trading process, but it is also part of ouredge. Only we as individual traders can make the assessment that “thetime is now” for our trade approach to be reasonably accurate, and onlywe as traders can admit it isn’t working. The less attachment we have toany one executed trade, the better our net performance will be; our trad-ing methodology will never have 100% winning trades in any case.

Our first loss is our best loss because a loss tells us something veryimportant. A loss tells us that we are on the losing side of the order flow atthis moment. That doesn’t mean our trade hypothesis is not going to bethe correct one at some point; it doesn’t mean we as a trader have donesomething “wrong”; and it doesn’t mean we won’t be able to make anothertrade from the same side and have it work at some later time. The onlything you need to accept from a loss is the education it brings. If you as atrader ignore that knowledge, refuse to admit your hypothesis is not anaccurate accounting of the market structure, or justify executing againfrom the same side again without thinking it through, you run the risk ofmaking another loss for the same reason—not knowing the order flow.

Your first loss is your best loss because it opens your information flowto the only two real issues of participating: (1) Get on the right side; (2) ifyou are on the wrong side, get out. Ignoring, blaming, justifying, gettingangry, whatever you feel or do with your first loss does nothing to preventanother loss. The only thing that prevents another loss is finding out whatcaused this first loss and discovering whether your attachment to your in-tended result is part of the problem. If you have done a masterful job ofpre-trade research and come to a reasonable conclusion that is strongenough for you to commit yourself, you need also to have a reasonableamount of willingness to admit that your hypothesis may be early or in-correct completely. Suppose you are 100% correct but six months early.You could burn through a lot of your trading capital by ignoring the lessonthat your first loss could teach you. If your trade hypothesis is completelyinaccurate, then you are facing the prospect of a total loss if you ignorethe lesson revealed by that first loss.

Your First Loss Is Your Best Loss 45


If you can honestly say to yourself, “I don’t care what happens on anyone trade,” you are a lot closer to getting the real answer to the question“What created the loss?” because the only thing that creates a loss is beingon the losing side of the order flow. If you can lay aside all your study,analysis, pain of a cash debit in your account, or emotional frustration,then you most likely can look objectively at the market and find the cluesto its actual current structure at that point. Getting on the winning side ofthe order flow might mean opening another trade from the same side atthe same price, or it might not. You might be fairly close to the turn for thenext big move, but maybe you won’t see it at all if you won’t accept thelesson that the first loss is teaching you: “Not yet.”

This rule can be a powerful tool for your long-term success. Having aloss for all the right reasons may sound like an oxymoron, but the under-lying psychology of this rule carries real benefit to you. A loss simply tellsyou that you might be early. That is a good problem to have. In the finalanalysis, you must exercise some kind of foresight to be able to exploit atrue inequality in the markets. Having that foresight is something that canbe developed. Once you have developed that foresight to some degree,you will also need to develop the ability to time your trades close enoughto where the actual change in the order flow is developing. Regardless ofhow well you personally develop that skill or how you personally createand maintain your edge, you will often be early sometimes. Assume youwill have that problem, and take the point of view that your first loss is amegaphone.

Remain completely unattached to the results, seek to understand theorder flow, and let your first loss tell you something about how you pickedthat spot. Don’t argue with the market. Listen to what it is saying. Be will-ing to accept the possibility that your hypothesis is completely inaccuratefor the moment.

46 CUTTING LOSSES


47

RULE #8

Never Addto a Loser

If you don’t know who you are, the markets are an

expensive place to find out.

—George Goodman (paraphrased)

For the most part, almost all losses can be traced back to the sameroot problem. By losses, I don’t mean the usual and reasonablewinners-versus-losers results that successful traders have; I don’t

mean “a particular losing trade.” In this case I am talking about a con-sistent and net losing result that occurs over time. The inability to cutlosses is the symptom; the actual problem is nearly always a variationof the same basic theme. Most significant or consistent losses are a re-sult of some form of attachment to results on behalf of the trader. Notplacing initial stop-loss orders, holding losing trades past a reasonabletime, overtrading, and so on are all symptoms of an emotional attach-ment of some sort. In those cases, the trader simply cannot let go andexit the market. Nothing announces that you have this problem louderthan adding to a loser.

This rule, “Never add to a loser,” is first cousin to Rule #7. In the casewhere a trader feels compelled to add to a losing position, the problem isactually a more severe manifestation of attachment. In the case of a lossgetting larger than originally intended or several small losses all adding upto a large cash debit, the problem is probably a lack of discipline or a de-nial of the actual net order flow. In the case of adding to a losing trade the


attachment is now a more internal conflict inside the trader and shows adramatic form of inflexibility.

In this case, a trader is unwilling to see objectively, and the cash lossis ignored while at the same time risk exposure is willingly increased. Allother common-sense concerns that at any other time a trader wouldagree were in the best interest of his account are completely discarded.The trader is actively participating in his own demise. Somewhere insidethe trader there is a conflict, and that conflict has nothing to do with mar-ket price action or the net order flow. It has to do with the trader’s ownunwillingness to protect the account, his need to be right, his hope thatthe market will come back, or any other justification process he mightuse for holding on to a losing trade in the first place. But instead of sim-ply holding a loser past a certain point, in this case the trader actively in-creases his risk.

If we stop and use a clear head when we trade, what benefit could wereceive by willingly increasing our risk and our cash loss? There is no ben-efit whatsoever as far as our long-term trading success is concerned. Whythen do some traders add to losing positions?

The reasoning behind “Never add to a loser” is very simple: Don’tthrow good money after bad. The only way you or any trader could be inthe position of adding to a losing position is if there was a failure to definethe risk before the trade was done in the first place. Rather than accept areasonable loss and learn the lesson that loss has to teach you the trader,the trader now makes a conscious and deliberate act based not on the factof the net order flow but on the trader’s own emotional need for some-thing. That need may be a need to get back a loss, a need to fight with themarket, a need for the market to pay a profit, a need to make a car pay-ment, or any number of little ways of saying the same thing. By adding to aloser, the trader is complicating the process of cutting a loss, thereby mak-ing his situation more difficult, but this act is based on something the mar-ket has no knowledge of to begin with: the trader’s own emotional need.

Remember, the market moves only because of the net order flow im-balance. Once you have executed and are now in a position, you are nolonger in control of the net result to your equity. If you are not on the cor-rect side of the net order-flow as far as your chosen position is concerned,your account will accrue a cash debit until either you liquidate or the netorder flow turns in your favor. If the net order-flow never turns in your fa-vor it is possible you could run out of margin funds before the price actionstabilizes. By doing anything other than liquidating, you are increasing therisk that you will suffer ruin. Adding to a losing position is actually pyra-

miding your loss! As an intelligent individual, how ridiculous does thissound to you? What trader would willingly put himself in the poorhouse ata geometrically faster rate?

48 CUTTING LOSSES


As a serious trader looking to master your game, you cannot affordto allow emotional or perceived psychological needs to influence yourwillingness to protect yourself. The reason you must never add to aloser under any circumstances is because the probability of being onthe correct side of the order flow has already become evident due tothe open-trade loss you are already holding. You are on the losing sideto begin with; you haven’t seen it right, and that fact alone, in and of it-self says “liquidate”—nothing else. Failure to liquidate means a biggerloss. Adding to the loser means an even bigger loss. How is that in yourbest interest?

Ask yourself exactly why you feel the desire to add to an existing loss.If you take a step back and think it through, the reason will most likely besome form of emotional attachment to the trade results and some form ofunwillingness to do the right thing. Adding to a loser is a symptom of abigger problem the trader has: no real control over his feelings or emo-tions. A trader in that position is an accident waiting to happen.

Some traders make the mistake of defining a losing trade as a functionof cash debit. By that I mean, an entry execution is followed by a liquida-tion execution and the two prices marked into the trading account yield anet negative dollar amount. I think it is far more beneficial for you to rede-fine the concept of a loss to include more focus on the issue of personaldiscipline.

If you find yourself executing into a market for some reason and, onfurther evaluation of your actions, you come to the conclusion that youare doing the wrong thing for you personally, then you need to liquidate toexit the market immediately. If you have broken a trading rule, if you havedone a trade because of something you normally wouldn’t trust as an indi-cator, if you have emotionally wanted a profit, or whatever other misstepyou may have made, you are most likely taking more risk than you other-wise would have. Ruthlessly liquidating to protect yourself is your bestoption, even if the trade has an open-trade profit at that point. A losingtrade can be any trade done for any reason if your personal discipline hasbeen broken in order to make that trade.

Once you redefine a losing trade from the standpoint of your personaldiscipline and not as a change in your cash balance, you are in a positionto learn what you need to learn from your first loss—how to effectivelyparticipate on the right side. The issue of adding to a loser is never inquestion because you aren’t trading from a financial focus to begin with.You are trading from the focus of discipline to do the proper thing all the

time. You will not be tempted to add to your loser because you will havecut the loss by liquidating. You can always get back in, so there is no needto hold something that isn’t working and certainly no need to make mat-ters worse by adding to something that isn’t working.

Never Add to a Loser 49


Fundamentally, making this rule work means admitting to yourselfthat you need something to control your emotional bias as it creates yoururge to action. You need to confront the possibility that you personallyhave a “something” somewhere in your thinking and recognize that thatparticular little something has nothing to do with successful trading. Thenext time that particular little something shows up for trading, you willhave already decided that you are not going to break your discipline to-day. The urge to add to a loser is a signal to liquidate because something

is not right with me today. If something is not right with you, the trader,that has nothing to do with market structure or where the net order flowis. If you aren’t seeing it correctly today, that is clearly shown by an open-trade loss to begin with. At that point you liquidate.

Making Rule #7 work will lead to never breaking Rule #8. The only dif-ference between the two is the trader’s depth of attachment to the trade.

50 CUTTING LOSSES


51

RULE #9

Don’tOvertrade

I will say this again, I never made my money by

trading; I made my money by sitting tight.

—Jesse Livermore

Overtrading is the definitive symptom of the net losing trader. All theother errors that can increase the net outflow of trading capitalfrom a trading account can be found when you examine the

amount of executions done overtime. Could you say that adding to a los-ing trade is overtrading? Isn’t it true that too many trades are often doneby failing to define a risk?

As I mentioned in the Introduction, most of the trading rules we arefamiliar with need to be examined from the perspective of the psychologyeither helping us develop or preventing us from developing. Many peoplearrive at Rule #9, “Don’t overtrade,” as a wake-up call only after it is toolate. To make this rule work we need to understand that it is a guidelinethat will help us prevent blowing ourselves out of the water. In reality,overtrading can be many things, but one thing is certain: Ignoring the poten-tial we have to overtrade will almost surely put us in the position wherewe have overtraded—and by the time we wake up to this fact, our equityis gone.

Part of the problem we as traders seem to have is processing the volu-minous amount of market information and opportunity base that is avail-able to us. At this critical point in monetary evolution, the financialmarkets are exponentially growing in both size and complexity. In additionto the explosive growth across virtually all sectors of money management


services, the evolution of communication is also growing at a phenomenalrate. At the time of this writing, any individual with reasonable means lo-cated in a developed area has instant access to almost any other indi-vidual, source of information, or market center anywhere in the worldinstantaneously via the Internet, cell phone, or television. I live and work indowntown Chicago, but if I wanted to I could have complete access toeverything I have now from a sailboat in the Caribbean or a mountaintop inIndia; and so could you. As traders we are no longer limited by distance orconnectivity to any market or information base. If we perceive that an op-portunity exists in an area somewhere on the other side of the world fromour home, we can choose from an almost unlimited number of ways to ex-ploit that opportunity and an equally unlimited information flow to managethat opportunity.

A key to cutting our losses is selecting which opportunities are thebest profit potential for us personally and if the truth were told, we re-ally need only one market. The fact that we can actively participateglobally at any moment contributes at least in part to the problem ofovertrading.

Many traders make the mistake of thinking that the term overtrading

can only mean excessive trading in a particular market. Although that isone aspect of it and needs to be addressed as part of your loss-controlstrategy, it would be far more accurate to rephrase this rule as “Don’tovercommit.” It really doesn’t matter precisely what that means for youdirectly, but as a serious student of lasting trade success, you must makechoices about how to allocate your limited resources. No one has unlim-ited capital and no one has unlimited mental or emotional resources. Yes,you must have controls on your behavior to prevent excessive tradingwithin one market, but you must also narrow your focus down to a spe-cific number of markets and the reasons you trade them. It is unreason-able to think you will perform equally well in all markets across allopportunities.

Without a solid understanding of each particular market and howeach is structured, you will run the risk of having losses you cannot ex-plain to yourself. Worse yet, because you cannot easily find the cause of your lack of profitability in one particular market, you will mostlikely continue to have losses in that market. Many traders have com-plained of net losing years or flat years while showing closed profits inone market against closed losses in another. The common complaintgoes something like, “If only I hadn’t traded in crude oil! I made six fig-ures in the S&Ps!”

Learning to stop overtrading requires a willingness to limit your op-portunity base while simultaneously maximizing your effectiveness in themarkets you will trade. It does no long-term good for your trading account

52 CUTTING LOSSES


to have significant gains in one market offset by losses in another. Addi-tionally, overtrading is a symptom of a trader’s impatience with the oppor-tunity he has selected or frustration over the results he has achieved. Nolong-term successful trader ever complains about opportunity or howlong it takes to develop. Such a trader has learned that certain times arebetter for executing than others, and that no matter what, it will takesome amount of time to see results. If nothing is happening today, thennothing is happening today. The market that trader is working in simplydoesn’t have a lot to offer at this particular time. The wise trader is notconcerned with that issue because he knows how to trade that marketand he doesn’t have his focus degraded by trying to put effort into sevendifferent places which he can’t exploit as effectively as he can one.

Because we as traders have so many choices and so much informationavailable to us, we are tempted to think all perceived opportunities will re-main actual opportunities for us personally, simply because we have ac-cess to something we ordinarily may have never known about before. Wethink that access to information is a de facto source of opportunity, whenin reality our own ability to manage opportunity and information flow isthe real key to our long-term success. One aspect of making the rule “Don’tovertrade” work for you directly is to narrow your focus to the best possi-ble market opportunities for you personally and limit your informationflow to only the critical information needed to exploit that number of mar-ket opportunities.

As an example, if you cannot understand why China is the fourth-largest economy in the world today but won’t revalue their currency to re-duce their trade surplus, then buying a China-based mutual fund for yourlong-term IRA stock account may not be a good move, even though thatfund meets your basic criteria for risk/reward ratio and has four confirm-ing technical indicators that you have come to trust well. Letting that tradego because you don’t have time to understand global economics wellenough to know when it will be time to liquidate that trade might save youa significant amount of capital should you miss something along the way.The fact that you can follow the Hang Sang index in real time and get Eng-lish-translation market commentary twice a day from Hong Kong does notmean you will be able to put it together well enough to effectively tradethat opportunity from your home in the United States. It is tempting tothink you can, but you might be overtrading your limited resources if youcan’t. A 40% loss in something you don’t understand rips the bottom out oftwo solid years in a “beat the S&P 500” trade you found. I am not saying itis a bad idea to consider globalizing your opportunity base. I am saying it isa bad idea to spread yourself too thin just because you can.

The common understanding of the rule “don’t overtrade” is related tomultiple executions within an existing market you currently trade in. This

Don’t Overtrade 53


rule is designed to prevent you from exposing yourself to excessive low-probability trades. The most common symptom of breaking this rule is ex-ecuting multiple times from roughly the same area on the same side, butalso taking multiple losses. Basically, you make six or seven trades fromthe long side, for example, and have five individual losses and a net loss onthe day. To make matters worse, if you would have just sat tight on the firstposition for the whole day, you would have had a nice gain by the close.

Overtrading (as defined by multiple executions) is a function of notunderstanding your time frame properly, not following your rules to beginwith, or not following your trade system properly. When the traderchooses to do something he ordinarily wouldn’t do, he is showing hisemotional attachment to his results instead of maintaining a focused be-havior congruent with his discipline. Overtrading is a symptom of attach-ment, as is all consistently losing trading behavior.

To make this rule work for you, create a baseline of behavior that isconsistent with your trading system and your trading plan. It really doesn’tmatter what that baseline is initially, but you have to create it as anindependent set of behavior controls, separate from your trading systemor plan. For example, if you are using an execution system that makes atrade call about once a day, and you are using that system properly, itwould be rare for you to have four executions to initiate in a single day ina single market. If you find you are executing more aggressively than thesystem actually tells you to, then you are overtrading. It is not a subjectiveor emotional set of data; it is a factual set of results that says, “You are notfollowing the rules today.” It doesn’t matter if your system is a moving av-erage crossover signal with a 15-minute moving average convergence di-vergence (MACD) confirmation; if you aren’t following it, you actuallyhave no system. And it doesn’t matter if your trade plan calls for you totake a break after two consecutive winning weeks and take your family todinner with some of your profits; you aren’t going to have any profits.

The symptom of overtrading is often subtle so that by the time youare willing to admit you are doing it, the damage is done. Therefore, tomake this rule work you have to choose ahead of time to put controls onyour behavior before you overtrade. You must write yourself a few rulesthat lead to preventing overtrading, not helping you recover after youhave done the damage. That rule set is unique to you—it is a factor ofyour particular systemized approach and what it would look like if youweren’t following it.

The key to making this rule work for you is to ask yourself what itwould look like if you were actually overtrading, based on the uniqueprobabilities inherent in your trade system being compromised. Once youhave that data, you must create a rule that would prevent that happening,if you follow it. In many cases, traders do not really know what their

54 CUTTING LOSSES


trade system probabilities are and therefore can’t really get the data toknow what overtrading would look like. Overtrading is not as simple as“trading too much.” If your system has a 55% probability of a winner butgets two-thirds of those trades on a Monday, you would be overtrading ifyou did a large number of trades on a Friday; so for you and your system,the definition of overtrading is not necessarily relative to the total tradescreated by that system. In this case, the rule “Don’t overtrade” might meannot trading more than twice on a Friday, but that wouldn’t apply on Mon-day. Maybe Monday’s rule would be “Don’t trade more than eight times.”

Gathering the data to exploit your system’s inherent probabilities isone thing, but putting controls on your behavior when you are outsidethose parameters depends on your knowing the difference. In any case,your trading plan is worthless if your systemized approach is not beingfollowed properly. The rule “Don’t overtrade” is a call for you to get gooddata and then implement it into your trading plan. That includes bothknowing which opportunities to trade in the first place, and being willingto admit that you may be not be exploiting those opportunities as well asyou could. Both sides of the overtrading issue are about reducing risk ex-posure until you have the data to make a significant improvement to yourmarket presence. The goal, of course, is to gather both the data and thewill to follow your rules before burning through all your capital.

Following Rule #9 can boil down to answering this question as hon-estly as you can:

“How well do I know what I am doing, and am I willing to admit Idon’t?” If the answer to that question is anything other than “I know ex-actly and I don’t need to change anything,” you are most likely overtradingin some form or another. You are either trading too many markets for you,trading without knowing your exact probabilities, or doing a little of both.Reducing your exposure or knowing when to stop executing (or a little ofboth) depends on your willingness to control yourself. Unwillingness tocontrol your behavior is what leads to breaking every other rule. Over-trading is the most important symptom to look for. We find out how badwe have the problem next in Part III, “Letting Profits Run.”

Don’t Overtrade 55


PART III

Letting Profits Run


59

RULE #10

Keep GoodRecords andReview Them

Mistakes are a fact of life: It is the response to the

error that counts.

—Nikki Giovanni, Forbes Thoughts

on Opportunity

Many traders experience an initial level of success easily right atthe start of their trading. They open their first account and be-gin trading, maybe with a very simple approach, and with only a

handful of trades they earn a substantial gain in a short period of time.Naturally, it would be easy for the trader to make the assumption, “Thisis easy!”

Of course you know the rest of the story. Over time this particulartrader loses his initial winnings and then proceeds to lose some or all ofhis initial balance just as quickly. Some traders repeat this process overand over again with a new trading stake and a new system. It is verytempting to think the problem was the system used the first time, ormaybe the amount of capital wasn’t big enough to take advantage of thesystem’s full potential and probabilities. It is very easy for people to makethe erroneous assumption that they know what they are doing only be-cause they have a little early success at something.

Very few traders want to admit that much of their beginning successis due completely to luck. But the fact of the matter is if you did knowwhat you were doing or had really found the perfect system, you wouldhave a consistent positive result no matter what the market conditionsare. Some people are better at this game than others, and their success


is the result of a programmed and proactive methodology involvingevery possible advantage a trader can find that can be applied with flaw-less discipline.

To accumulate consistent and significant profitability requires doingsome things that at first may not seem valuable. But true professionaltraders will tell you that getting to the point of solid success that can beconsistently duplicated in any market requires perfect application of skilland knowledge.

So where do you get the knowledge and how do you acquire the skill?In this part of the book, we are discussing the rules for letting profits

run. Most traders feel that a proper discussion of letting profits run wouldbe market-related and include lots of details on stop-loss placement,adding to open positions, expanding time frames, and so forth. But in myview, the most significant part of getting more money out of your winningtrades is to know exactly how you created them and then duplicate thatsuccess more often. If you do not know exactly how you created a win-ning trade and then know exactly how you can duplicate that winning be-havior again and again, your gains are at best limited or, at worst,completely due to luck. You must know what you are doing right and whatyou can improve. This is more than a vague agreement you have withyourself; this is a matter of getting data. The pathway to more consistentprofits is record keeping.

Why record keeping?Think of a book that you were required to read during your college

years. No matter what your initial response to your course load or evenyour particular interest in your course work, you were not going to pass anycourse unless you absorbed the material required by your teacher and coulddemonstrate to his satisfaction that you had that knowledge inside yourhead. You were required to read that book, make critical distinctions aboutthe point the author was trying to make, and then you would be given a test;and if you failed the test you got no credit for the course. That is a fact.

In the world of the markets the process is really not materially dif-ferent. You need certain knowledge and if you can’t pass the test (tradesuccessfully), you get no credit for the course (you don’t make anymoney). To make things a bit more complicated, you have probablyguessed that there is a book or two you will need to read to acquire theknowledge you need to pass the test. The twist is that you write thebook you need to read.

Record keeping is your most important asset in your quest to masterthe skill of letting profits run. By compiling a complete and accurate writtenrecord of your personal trade approach, an accurate accounting of yourmental and emotional state, and the actual record of how well you are fol-lowing your trade system and your trade plan, you create a huge database

60 LETTING PROFITS RUN


of information you can now use to learn from your own actions what youare doing that works and what you are doing that needs to be improved oreven eliminated from your behavior. By critically reviewing things like yourrecords of execution for entry and exit, when you made a change in yourposition, trades you didn’t take, your notes about your thinking, and so on,you have the hard data required for you to ascertain what you were doingand what you were not doing. Your records are a factual accounting of

what happened, leading to the results you now have. You can see by studyexactly how you created a winner or loser at a particular date and time. Youcan see similarities and inadequacies. You can understand parts of your ac-tions and how easy it might be to change some behavior that usually leadsto a loss or cuts a profit short. In short, you have the data you need to criti-cally examine in order to pass the test required to receive credit for theclass—to pull the most money out of the market.

The true and lasting benefit of accurate record keeping is the ability toobserve from the outside your behavior as it actually is when you trade.As you compile more and more data about your actual behavior and seeclearly how that differs from your desired behavior, you create a source ofinformation that can assist you in modifying your behavior. In the finalanalysis, your actual behavior is what creates your actual results. If youare willing to admit that it is your behavior that creates a larger loss, cutsa profit short, hesitates at the best entry or exit point, then you have achoice to modify your behavior and increase your probability of success.You have the ability to see clearly where in your behavior you are doingthings that lead to losses and where in your behavior you are cutting yourwinners short. After that point you can now create rules to modify yourbehavior and those rules are the same ones we discuss here, with one im-portant distinction: You now know where the problem is for you person-

ally and you now know you can fix it.In my view, accurate record keeping is not as simple as “writing every-

thing down.” I think you will achieve more lasting success as a trader ifyou know what you need to keep records of and exactly what you arelooking for inside that data. Gathering hard data in the arena of trading isboth an inner and outer process. You need to accurately record all of yourouter behavior, which includes execution entry, stop placement, movingstops, setting limits, adding to positions, taking off positions, final liquida-tion, when stops/limits were filled, dates and times of all these actions,and the net gain or loss to your account.

Inner data is far more valuable and difficult to document, but the in-ner data is the real meat and potatoes of getting better at trading. Re-member, no matter how you want to slice it, you must be on the properside of the net order flow reasonably close to your entry point in order toat the very least have an open-trade profit working for you. If anything is

Keep Good Records and Review Them 61


getting in the way of your seeing the most probable point where the netorder flow is likely to change, your probabilities of success on that tradeare lower.

One thing you must do in the record-keeping process is to documentexactly what you are thinking and feeling when you execute. Keep a writ-ten journal of your thoughts and emotions. The sole purpose of this docu-mentation is to expose to your conscious mind the true nature of whatyou are using from your inner world when you execute, move orders, takeyourself out of trades, or refrain from taking trades. All of your thoughts,perceptions, feelings, desires, motivations, and so on boil around insideyour internal trade-making software and finally create an urge to action—the reason why you pull the trigger at that precise spot.

The sum total of your inner world is what creates your account bal-ance for the simple reason that you see the market the way you see it. Yoursystematic trading approach is an attempt to create a sense of order to un-derstand the apparent chaos of price action. It is designed to help you findthe best possible point for a change in the net order flow, based on somehypothesis of probabilities that you hope are usually present under certaintime frames. What your system really does for you is give you enough con-fidence to execute. It gives you that confidence because the systematic ap-proach is based on a set of assumptions that you can agree with ahead oftime. All you need to do is follow the system—but market conditions andyour personal state of mind may not be exactly right for that system today.

When you make the choice to trade or not trade for some reason, youcreate only one of three results: made money, lost money, or stood aside.No matter the results in your trading account, there was movement in themarket anyway. If you see that movement as a potential profit you missed,a potential loss you avoided, a trade you shouldn’t have done, or a tradethat was done right, you are no longer trading the system. You are tradingyour point of view on the results of using or not using the system. Themarket itself had no knowledge of your participation or absence, and yourresults had nothing to do with the net order flow.

This inner data is invaluable to know about yourself because it willexpose your thinking process for what it is at the time. After critically ex-amining your thoughts and emotions, comparing them to the financial re-sults in your account, and then finally to subsequent price action, you willsee how fear, greed, or hope was involved in your execution instead ofclarity of observation or discipline. Once that is clear to you, the choiceto change both your thinking and your behavior is yours. If you know thatwhen certain things are going through your mind you are about to eithermake a losing trade or get out of a winner too soon, you can make thechoice to stay out or hold on a bit longer. Your confidence is better be-cause you control your behavior better.



Record keeping on both levels will give you that extra data to learnwhere you are strong and where you are weak in your trading approach.After critically examining your own documented behavior you can seewhere you excel in trading, and you can then duplicate that winning be-havior. You will also see where your behavior is weak, and you can putcontrols (rules) in place to minimize their effect on your execution. In theend, it is only your behavior that creates your results. You need to knowwhat behavior works and what behavior doesn’t, and in most cases thatdata is in your head when you trade. Get that data out on the table andstudy it.

In the Introduction I briefly discussed one change I made to my trad-ing approach after I started to keep good records and review them. Ilearned to stay out of the market when I personally needed to and to trustmy analysis. Making that one change put me on the right side of the net or-der flow better, which allowed me to hold my winners for the best poten-tial. Yet when I reviewed the records after that point, I discovered that mytotal trade results where not materially different; I had about the samenumber of winners and losers and made about the same number of tradesin a quarter. Most of my net gain was from only a handful of the trades—the ones I was holding. I plotted this data using a standard bell curve andplotted my previous results on top of that. I discovered that from a pureprobability standpoint, nothing had changed. So why was my account bal-ance higher?

My account balance was higher because I held my winning trades andmade fewer total trades before the winning trades. Prior to the new rule Ienforced on my behavior, the overtrading yielded small gains and losses,and that kept my balance orbiting around a basic area of pre-winner loss.By not having those losses to overcome, when I would hold the winner forthe pull, instead of overcoming a loss prior I was adding a profit prior. It issimilar to positive cash flow as opposed to negative—like getting paid,paying all your bills, and having nothing left, versus paying all your bills,getting paid, and having no obligations. My account balance went higher,slightly lower, higher, slightly lower, instead of going lower, slightlyhigher, lower, slightly higher, yet the actual trading was about the same. Ireally didn’t do anything different in my analysis or trade selection; I justgot positioned better by knowing where I was weak and knowing where Iwas strong. My record keeping showed me that, and if I hadn’t kept thoserecords I may have not learned that as quickly or had the data to makethat small change.

Keep Good Records and Review Them 63


65

RULE #11

Add toYour Winners

He that would have fruit must climb the tree.

—Thomas Fuller

No one can successfully speculate to their full potential until theyhave the capacity to consistently add to winning positions. I makethis statement for three reasons. First of all, the pure probabilities

of any systemized trading approach will always be subject to a ratio ofwinning trades to losing trades. If, for whatever reason, the winningtrades are not maximized to their full potential then your net resultsover time will usually never be more than average across the entire sam-ple set.

I would encourage you to do a little homework on various systemsand their net results over time. You will discover that almost all systems(no matter how they were developed or the theory behind them) suffer aperiod of drawdown that reduces their overall net results. If the user of agiven system has used it for any reasonable amount of time prior to thedrawdown point, no matter the previous success earned, the results areusually no better than a small gain or loss. If the user of that system hasonly used it a short time prior to a drawdown, then the results are usuallynegative to the account equity. This, of course, does not take into accountthe actual trader executing and how well he follows the system to beginwith. Many winning systemized approaches are negated by the behaviorof the trader using it.

Second, market quality is never discussed in system methodology. Allback-testing is based on the “if–then” assumption that conditions in any


market will be basically identical in time forward as they were in timepast. In other words, the system is supposed to create results, from thepoint it is actually used in a real trading market, similar to those it gener-ated as it hypothetically performed in markets that had already beentraded. But the underlying conditions of that back-tested market cannotbe duplicated forward, and the system methodology cannot account forunderlying conditions as they may change. Therefore, the establishedprobabilities learned from the system’s methods may not be duplicated ifunderlying conditions are creating price action that the system has neverbeen exposed to before. The system’s win/loss ratio might be higher orlower and the money taken from winners may not be enough to overcomethe money lost on the losers.

Part of the reason that systems have drawdowns to begin with isbecause the system is being overlaid onto a market that has a differentunderlying condition than the one that the system methodology was de-veloped under. The perfect example is a trend-following approach beingoverlaid onto a market that has stopped trending due to a change in theunderlying fundamentals and/or the perception of traders. The win/lossratio will most likely drop and the losing trades will most likely be largerthan the winning trades. Adding to the winners in this case becomesmore critical if you intend to keep using that system while you wait forthe resumption of trend.

Third, adding to winners is the best method of letting profits run forthe simple reason that the net order flow in the direction of your trademay continue for quite some time past your initial best estimate. When wediscuss using multiple time frames (Rule #12) and buying and selling 50%retracements (Rule #25), you will have more tools for adding to your win-ners because often the depth of the net order flow can develop over time,and it may not be apparent until you have been in the trade for a while.Sometimes the quality of the market changes in your favor to a deeper andmore definable way after you have executed to take your initial position.Being alert and ready for this eventuality is the psychology behind Rule#11, “Add to your winners.”

Adding to your winners does not necessarily refer to a particular pricepoint. It is often a price/time relationship. For example, suppose youhave established a particular market position for a period of time and itcurrently has an open-trade profit, but the market itself has started to con-solidate between two very well-defined price areas. Having done yourhomework, you already know that this particular market is subject to con-solidation when waiting for a particular set of fundamentals to develop.You already know that conditions are bullish and you are waiting for thatconsolidation to break out to the upside, but that would mean a new



monthly high for that market. The fundamentals are due at the end of themonth, and prior to that point the volume has been dropping daily, but themarket is remaining well bid during this time.

If the market breaks out to the upside, you want to add to your openlongs because a new monthly high will attract a lot of attention from peoplewho may be waiting for some sort of confirmation before committing them-selves to a long position. As the time approaches for the new set of closelywatched fundamentals to be released, you notice that the market firms nearthe top of the range and volume is increasing a bit. Now the news is releasedand the market breaks out to the upside and never looks back. That wouldindicate that a potentially new net order flow is coming in, and even thoughprices are now at your first objective on your first long, the better thing to dois hold that trade and add to it because now the long position has more po-tential than you first anticipated—and you are already there with a lead.

Of course, if the opposite had happened, you would also know thatthe potential in the long position is dropping and you might want to liqui-date; but that is another issue. In the case of an upside breakout at a sig-nificant price/time relationship, you have a new clue that something ischanging, and that very well could mean more potential in the directionyou had originally participated in. You need to press your advantage andnot only hold that winner but consider adding to the open trade for a max-imum gain. A system cannot account for that potential; only you can.

On a close and reverse strategy the same thinking applies. If you areaggressive in one direction and something changes—not only liquidatingyour open trade but reversing completely and holding a new trade in theother direction, if that price action is more aggressive and maybe evenbreaks back through your original price from the first trade’s entry—youare in a position where you could very well have tapped into a very largenew net order flow and you are apparently on the right side. You need toconsider adding to the second working trade. Some old trading rules actu-ally are based on this thinking, one of which is “Buy/sell a reversal backthrough the opening range.” In today’s 24-hour marketplace this rule is ob-solete in many markets, but the psychology is the same: Add to your win-ner when the net order flow is very clear to be expanding in your direction.

The key here is not to say you will always add to your winners butthat you will always be ready to add to your winners when the net orderflow is clearly apparent to you and you already have a lead on the market.In other words, when you are seeing it clearly and you are being paid, askthe market to pay you more since it apparently wants to.

A key to making this rule work consistently for you is to develop themind-set that market conditions are dynamic. They are constantly changing.When they change in your favor you need to exploit that, especially when

Add to Your Winners 67


you are already in the market holding a winner. Adding to a winner is reallynot a factor of increasing your risk. Your risk is always identical all the time:“What if I am on the wrong side of the net order flow?” The fact that marketconditions can and will change is not the issue. The issue is getting paid themost when they change and losing the least when they change.

When conditions are not changing and a trade is working, at somepoint you want to add to that winner to maximize your profits. You wouldliquidate that trade at your objective anyway, regardless of whether youhad one contract working or a hundred. After you add to that winner, ifsomething changes against you, either you would take your position off orbe stopped out—again, regardless of whether you had one contract on ora hundred. However you decide that the rule set for adding to a winner isgoing to work for you, the strategy is less important than always being

ready to use it. If conditions change for the better in your favor, the issueof adding to a winner should never be in question. Press the advantagethat you already have.

Think of this rule as proactive. You are taking control of your ultimatetrading success by choosing to place yourself in the best possible profit.You are choosing to take what is there to get. Remember, this rule will notwork well for you if you add to winners hoping the market will continuein your favor. You need to be certain you have identified the remaining po-tential in the trade. Proactively choosing to say, “As long as conditions re-main as they are, I will take more out,” needs to be effectively balancedagainst “If conditions change, I am out.” There can be no other influenceon your adding to a position. You add when your level of certainty is high-est in your original trade hypothesis. As long as your hypothesis remainsthe correct one, you stay in that trade until your objective is reached orsomething changes.

Sometimes adding to a winner is a factor of conditions remaining thesame until you reach the objective. Sometimes adding to that winner is afactor of conditions unexpectedly improving in your direction. But in anycase, when you are on the correct side of the net order flow, once that issolidly confirmed to you, no matter how you choose to define it or whattools you use to confirm it, adding to that winner is your best option tomaximize your profitability and negate the opposing probabilities inherentin any systemized trading approach. Your systemized approach will haveweak spots and a drawdown can happen at any time. Remaining vigilantand prepared to add to a winner will help increase your chance of lastingsuccess. Part of your trading plan should include a regular assessment ofhow well you are applying this rule.

One consideration that will help you identify when it is time to add toan open-trade winner is a rise in volume on days the market is moving inthe intended direction. If that is accompanied by a rise in open interest, so



much the better, but you need to see turnover at times when the market isadvancing in your direction. Remember when we briefly discussed the is-sue of zero-sum transactions? The only trader who must execute is theone holding the losing position; he has to get out at some point because hecannot lose money forever. When that losing position is liquidated, at leastone contract is not there anymore, so open interest will drop. If this losingtrader reenters the market and then experiences another loss, volume willbe higher but the net open interest should still reflect his leaving the mar-ket. In other words, the same trader did one lot for a net loss on the day,but he did it four times. Therefore, volume is higher but open interest isaround the same for the day because he is not holding overnight.

Turnover on days when price action is net in the direction of your hy-pothesis usually means the same groups of losers are coming back and thesame groups of winners are taking their money. This situation gets betterif new winners and new losers are squaring off; a rise in open interest willresult. In this case, because the price action is still net in one direction, itis evident that the sum total of the orders from that side remains higherthan the other side, no matter who is winning or losing net on the day.The market will continue in that direction until everybody quits, which isshown by a drop in open interest. That usually signals you are near a turn.Watching for turnover is a great clue that it is time to add to your open-trade winner. If that is accompanied by a rise in open interest, you knowthe market has a lot of fuel left in it, so you can continue to add.

Maybe you could add every day for weeks and take it all . . .

Add to Your Winners 69


71

RULE #12

Use MultipleTime Frames

Think fast—act slow.

—Greek proverb

Most traders have had the frustrating experience of having a nicewinning trade suddenly reverse into a smaller gain or, worse yet, aloss, execute for their liquidation, and then watch that trade run in

their favor to a new daily or weekly profit level. Aside from placing theirstop too close (or panicking out), this problem is a result of not under-standing multiple time frames and how groups of traders on different timeframes compete with one another for control of the market. If you look atyour historical price charts, you will observe that retracements, falsebreakouts, reversals, failed reversals, washouts, and various other pricepatterns occur with regular frequency under all time frames. A short-time-frame price chart and a long-time-frame price chart will eventually havethe same or similar patterns develop; the only difference is actual time re-quired to create that price pattern or see that potential developing—“clock time,” if you will.

I find it is more helpful to think of price charts not in terms of atime frame per se but more as a number of bars. For example, a typicalpennant formation requires around 40 to 60 bars of “open-high-low-close” (OHLC) price bars to form and be observed as a potential pen-nant. On a five-minute price chart, that would represent about 200 to300 minutes of clock time—somewhere around 3.3 to 5.0 hours by theclock. If you have done your homework, you know that a pennant for-mation has a certain probability of a breakout at a certain time (about


two-thirds of the way forward from the mast or flagpole) and that theprice move is usually about the distance of the flat side of the pennant,one way or the other.

In other words, on a five-minute price chart, if you suspect a pennantis forming, it will take you about two to three hours to define it, andsomewhere around the four-hour mark a breakout higher or lower is ahigher probability. Additionally, most pennants on a five-minute pricechart have a flat side of some amount that is a certain percent of the day’srange. Armed with this data you now enter that trade, and if all goessmoothly, you might capture 80% or more of the breakout when it comes.But at that moment, a new level of order flow comes in and that marketreally takes off. And identifying that new net order flow is what makes allthe difference.

Using that hypothetical trade as an illustration, if you compare yourfive-minute price chart to an hourly time frame price chart, perhaps youwill then observe a different pattern that the last 40 to 60 bars have cre-ated. Upon closer examination you note that the pennant formation thatrequired 60 bars and 300 minutes by the clock is reflected on the hourlyprice chart as a double-top formation that required 6 bars and 300 min-utes by the clock. If your five-minute pennant formation had an upsidebreakout, once your price objective was reached, that most likely wasnear the top of the hourly double-top formation. Should the market nowattract enough buying to penetrate the hourly double-top, you would beout of the trade with a small profit just when the larger-time-frametrader is buying into the market and creating a bigger order imbalanceon the buy side. You have banked a small profit when you could havejust as easily had a larger one by simply noting that the smaller-time-frame bullish potential was contained within a larger-time-frame bullishpotential. Both time frames had a bullish potential that developed withinthe same 300 minutes by the clock, even though each price chartcounted it differently and presented that data to the observer (you) intwo different formats.

The concept of using multiple time frames has to do with understand-ing who is looking at what, and when those traders are most likely to addpressure to the order flow by entering an order. An hourly-based trader isthinking something different, and therefore executing differently, thansomeone on a longer or shorter time frame. When you have a lot of evi-dence on your side, in your time frame, that it is time to enter the marketfrom one particular side, how confident are you that more orders from adifferent time frame will also be coming in from that side? You can de-velop that confidence by seeing objectively what other time frames areseeing. When you then compare those viewpoints for congruency, if youhave a good sense that more than one time frame is thinking along the



same lines, you have more confirmation that potential net order flow maydevelop a little larger along that direction. To help you let your profits run,you need to recognize and exploit what every time frame might eventuallybe doing.

Your best trades occur when you have correctly positioned yourselfon the net order flow as traders in each successively higher time framechoose to execute. For example, if you are looking for a buy point, youwould like to see the 5-minute, 10-minute, and 15-minute price charts pro-vide similar clues, all at around the same price area. At the exact sametime, the 30-minute and hourly price charts are likely neutral or slightlybearish after a move to the downside has already happened. The daily andweekly price charts might show a down day or weekly low within abroader weekly or monthly established range.

Now, suppose you execute from the buy side and within 30 minutes orso you have an open-trade profit. Most likely you have correctly identifiedwhere the 30-minute-or-less trader is creating a buy-side order imbalancebecause prices are higher. That can’t happen unless sellers are over-whelmed under those conditions at that moment. If the 30-minute andhourly bars now trade higher, then you have a pretty good clue thattraders in the next higher time frame are also beginning to show up on the

buy side. If the market now continues higher and closes, say, in the upperhalf of the daily range, it is a fairly good bet that the daily-time-framebuyer is also executing. If the market is again higher for the next day’strading by the close, the traders looking for a potential low for the weekmay be active from the buy side. Your original entry on the shorter timeframe is confirmed by the longer-time-frame traders executing from thesame side. More traders are seeing the same thing, and the cumulative netorder flow is working from that side. In this illustration, competing timeframes became congruent as the market drew in the full spectrum of par-ticipants the more clock time passed. As time goes on, the market willcontinue to advance even when the short-term time frame produces a sellsignal because the larger time frame is still attracting order flow from thebuy side.

Now, bear in mind, I am not trying to oversimplify price action or get-ting positioned. I know that swings in price can be violent, the marketmight go sideways for a long time, and false signals frequently occur allthe time. Often trades that could have worked become losers for variousreasons. It takes time to get in a position, and it takes experience to knowwhen the move you are waiting for is developing.

The point I want you to absorb is that certain trades from one side de-

velop potential over time. Sometimes closing out your position with agood gain because it was one of the biggest moves you had ever seen un-der your time frame is the worst thing you can do. If the larger-time-frame

Use Multiple Time Frames 73


traders are drawn in from the same side, that particular market will have alot farther to go in your original direction. Of course, you can always getback in from the original side anytime you want, and maybe it is a goodrule for you personally to remain flat overnight; but if you are followingthis rule properly you will always look for clues that the winning positionyou just found and participated in has a lot more potential developing inthe same direction.

It takes clock time for all those trading time frames to become active.If traders in multiple time frames are coming into the market, your proba-bility of success is much better. When this rule is combined with Rule #11,you have a powerful tool to help you let profits run better. When a positionhas worked, consider that if it is still working a day or two later, you mightwant to look at that side again and also add to it.

Making this rule work for you requires you to think outside the box asit concerns your personal time frame. You should always have a timeframe that you execute under, but that time frame does not contain all theinformation about potential net order flow. The wise trader will considerwhat the traders with other time frames might be seeing, because at somepoint, when those other time frames are drawn in, their orders from thosedifferent time frames will either add to the net order flow that is develop-ing in one direction or it will overwhelm the net order flow from the otherside, stopping the imbalance and the price advance. Every trader who hasthe potential to execute will affect the net order flow. Whether thosetraders are using a larger or smaller time frame than you is not important.What is important is whether the potential they offer will be for or againstthe net order flow currently operating in the market. In other words, ifthey come in with their potential, will that potential increase the imbal-ance or reduce it?

By observing price patterns in several time frames, you can begin tosee which direction the market is more likely to go. By using more thanone time frame to evaluate a trade’s potential, you will avoid more low-probability trades. When several time frames are all saying about the samething and prices are advancing in that direction, as clock time passes, thattrade’s potential is increasing. If several time frames appear to offer con-flicting price pattern relationships, that trade most likely has a lower po-tential. As a trader looking for high-probability trades, develop the skill ofcomparing multiple time frames to your trade hypothesis. When you havea good idea that traders in the next few higher time frames are interestedin the same side as you are, you need to let them have the clock time theyneed to execute.

Also, be prepared for your time frame to give a liquidation signalwhen the higher time frames are getting their initiation signal. A key toholding your winners and using multiple time frames is learning that a



shorter time frame needs to offer a countertrend signal to encourage thetrader from the opposite side to initiate. That opposite-side order from theshorter-time-frame trader is what the higher-time-frame trader needs toexecute his initiation order. For example, if you are on the 15-minute timeframe from the buy side, and the hourly trader is nearing a buy signal, thehourly trader would like to see a sell signal on the 15-minute time frame inorder to encourage a new 15-minute time frame short to open that he canbuy from. Without knowing that the shorter time frame will be in conflictwith the larger time frame at the exact moment the larger time frame is setto come in on the advancing side of the net order flow, you might betempted to book a small gain in your time frame. Learn to let the largertime frames push your trade.

Use Multiple Time Frames 75


77

RULE #13

Know YourProfit Objective

If you don’t know where you are going, you will

probably end up someplace else.

—Yogi Berra

No trader will ever reach his full potential without some disci-plined method of getting out of winners when it is time. The winning trade that continues to develop potential is a different

issue. Profit objectives are necessary because you must have points inthe market where you make choices. Sooner or later it is time to liqui-date every trade and exit the market—the trade is over. When thetime/price relationship reaches that point, you liquidate and wait forthe next one.

The best time to make that choice is before you place your trade.Having a profit objective before you initiate provides good benefits for your developing trade methodology and your discipline. Profit objectives help you stay focused on getting paid the most from yourwinners.

Having a profit objective firmly in mind is crucial to lasting successfor two basic reasons. First, it helps you maintain the proper risk-to-reward ratio on your open positions. As we discuss in detail later, themagic numbers are 42% winning trades and a 2:1 money won/lost ratio. Atthis level of performance you have a winning approach, but if you don’thold your winners you can’t overcome your losers. Knowing how muchmoney you are looking to take on any specific trade helps you keep yourfocus on this ratio. Just knowing these ratios and attempting to define


your upside objective will keep you out of lower-probability trades. Plac-ing your exit orders at or beyond price levels that will maintain this mini-mum winning ratio does not insure that those numbers will trade, ofcourse, but having a resting order designed to take a profit allows you tobenefit from winning ratios and helps you stay disciplined to take win-ners—to help your approach’s inherent probabilities work for you moreoften than not.

Second, having a profit objective helps you fight the temptation toclose a winner too early, cutting your profit short. As long as your trade isworking, you have a better ability to sit tight; you are developing themuch-needed discipline to leave a good thing alone. No matter how youwant to slice it, no market will go straight up or straight down away fromor toward your profit objective. It will take some amount of time for thetrade to develop in order to eventually reach your objective. If you letevery little switchback or price hiccup scare you out of your winners, youcan’t pay for your losers. Having an objective firmly in place will give youthe perspective that is required to sit through and wait out temporary ad-verse price moves. Every market inhales and exhales.

Profit objectives are tools for effective trade management when hold-ing your winners. They help you focus on finding good risk/reward ratiosto begin with, but more important, they help you hold your winners forthe largest potential gain. As long as you take the point of view that profitobjectives are part of your tools, you will have more winners to start withthat you can hold longer.

I have found a few helpful tools that allow me to remain confident inmy profit objectives. First, look for a minimum three-to-one reward-to-riskratio. This is not your actual price objective; this is the money you intendto risk compared to the market potential you hope to find. For example, ifyou believe that a market is developing a short-selling opportunity, wherewill you place your protective initial buy-stop order, and how far can themarket go in your favor before the buyers step in and support it? If youare going to risk 50 points on a day trade, does the market have the poten-tial to trade at least 150 lower on the day? If the answer is no, then youmight want to pass on that particular short sale. You are looking for ahigh-quality relationship between your risk limit and your upside poten-tial. If the market has never had a 150-point day in its entire history, thenpassing up that trade is a no-brainer; most likely the market doesn’t havethat much potential for the day. Your goal with a risk/reward ratio is tostart from the premise that the ratio tells you how far the market mustmove if you take that position. Comparing your required profit objectiveto what you already know from your previous market study tells you bet-ter whether you really do have a potential trade with a higher or lowerprobability based on the parameters you have selected to trade with. You



need to compare that risk with what you have to get if you take the posi-tion. In other words, if you can risk 50 points and the market can’t pay youat least 150 (based on your study), knowing your required objective pre-vents you from placing a low-probability trade.

Having a profit objective also creates confidence to add to winningpositions. Many trades will have much more profit potential than origi-nally hoped for as they develop. When that potential becomes apparent,having an objective will help you ask good “if–then” questions to improveyour net rate of return. When you see clearly that your original objective isonly a small stopping point rather than the end of the trade, having a pre-determined mind-set to add to the winning position is a great way to re-main disciplined to work the winning trade until it is all over.

In my personal trading, I have two or three objectives for each positionwhen I initiate for my first entry. The first objective is the area where I feelthe market will have a pause, and a larger time frame trader must make adecision. For example, if I have bought an hourly low, my first objectivewould be the high of the day or previous day; that is most likely where thedaily or weekly trader will take notice and either cap that rally with sellingpressure or add to the net order flow on the buy side. No matter which hap-pens, the first objective is not just price; it is time and price. I want to seethe higher-time-frame trader push my trade with his order flow.

My second objective is the usual three-to-one reward/risk ratio. If Ihave correctly anticipated the net order flow, and the trader in the nexthigher time frame is joining the party, when the market gets to the price Iam looking for I must decide if the trade has developed more potential inthe same direction; that is a factor of time. If the rally has happened veryquickly, and the market traded the second objective price and thenbacked off a bit, most likely that is stop-loss buying as the losing shortscover and the larger time frame also liquidates. In this case, the rally maynot have that much farther to go and I would either take the profit or atleast roll a break-even protective stop. But if the rally took lots of time,there was good continued buying and selling from both sides as the objec-tive was reached, and the price stayed at or around the objective for sev-eral hours, then it is possible that even larger time frames are coming intoplay. The entry of traders in the next larger time frame may mean that thepotential for a further advance is still building. If the market continues tostay at or around the objective price while volume and open interest alsoincrease, the market most likely has further to go. I would add to the posi-tion by some amount because the potential to reach the next objective hasincreased.

Should the market continue to advance after the position is added to,then the next objective level comes into play. That is usually a price areawhere the larger time frames take a stand from the other direction. For

Know Your Profit Objective 79


example, in this case, an hourly low was the right area to get long a mar-ket that has now made an advance that the daily or weekly trader is alsointerested in from the long side. As we approach the monthly openingrange (for example), the monthly trader will now take notice. Since themarket had been lower up until that point, the monthly trader is mostlikely either looking at placing shorts out, anticipating a failure of themonth’s opening range, or looking to go long if he is certain that the rallywill continue. The net order flow will most likely start within a price/timerelationship that includes everybody. Once the price reaches the monthlyopening range, that price action will be a high on everybody’s price chart.

So now we watch for the hourly price charts to show some selling,then the daily charts to show some selling, and finally the monthly charts.If the process takes 24 to 48 hours of clock time, and the market itself islower for all those time frames, then most likely the traders in both thelarger and the shorter time frames are all liquidating. The trade from thelong side is running out of potential. The objective was reached and thetrade is over.

However, if the price action continued to show strength—for exam-ple, the hourly price chart corrected lower and then prices returned to thehigh end of the range, the daily price chart closed near the high and justunder the monthly opening range, it is a Friday afternoon and the profit-taking sell-off to close the week never happened, and so on—then thetrade may be continuing to build potential. If the market advances furtherthrough the opening range, in this example, it would be a good time to addagain to the position because traders in the larger time frame are nowadding net order flow from the long side as well.

Having a series of profit objectives in place before you initiate thetrade helps you to remain focused on the process of holding a winningtrade. Markets are dynamic and conditions are always changing. Profit ob-jectives help you maintain your edge for the simple reason that they keepyour attention on the things that really matter: Changes in the net orderflow as traders come in or leave the market. The important point of havinga series of profit objectives is that you look for something changing atprice/time points where it would make sense for something either tochange or stay the same. As your objectives are reached, price action willprovide important clues for you to review in order to have a degree of cer-tainty about liquidating, holding, or adding to the winning position. But inall cases, price objectives are important areas to have predetermined inyour mind. These are the places that you will do something or at least con-sider doing something. Whether the market ever trades to your price ob-jectives or beyond them is really not important. It is important for a traderto remain proactive in his trade management.



Price objectives are stopping points that help you maintain focus onyour trade. Having the price objective in mind before you place the tradewill help you choose better-quality risk/reward ratios to start with. Havinga series of objectives that are price- and time-sensitive and involve addi-tional behavior from multiple time frames will help you get the most fromyour winners.

Know Your Profit Objective 81


83

RULE #14

Don’tSecond-GuessYour Winners

In great affairs we ought to apply ourselves less to

creating chances than to profiting from those that

offer.

—François la Rochefoucauld, Forbes Thoughts on Opportunity

W ithout a doubt, the most profitable market potential you can iden-tify is a change in trend. When a market has stopped moving inone direction and is about to begin a move in the other direction,

that potential might take time to fully develop but it is your lowest-risk,highest-probability opportunity. You are literally sitting on top of a goldmine. Getting in position early takes effort, but once you have establisheda base position, you need to let the trade work.

This is different from simply holding a winner. This is more an issue ofmaintaining proper focus, continuing to do the analysis needed to identifyfundamental and technical potential, maintaining constant vigilance onnet order flow as it changes, and sustaining a strong belief in yourself andyour ability. Your trade hypothesis is developing and the time needed for atrue change in trend to manifest might be quite long. The last thing youwant to do is reevaluate what is happening and exit the trade early or,worse yet, reverse your position.

Personally, I can show you trade records where I have been at theprécis point in both time and price to be long or short from the changein trend, sometimes from a yearly or multiyear high or low. Did I getpaid? Yes, but not what I could have. I second-guessed my hypothesis.


Looking back, I can see that it was mostly because I lacked the focusand discipline to just leave well enough alone. What stands out in mymind most is the high in the orange juice market for 1991. I was shortfrom $2.06/Lb. I covered at around $1.95/Lb. Yes, I made a nice gain onthe trade, but within a year that market was over 50 cents a poundlower.

During the time the market was under selling pressure, I kept looking for another short position to put out on a rally. I convinced myself that the initial break was too fast and that a re-test of the highswas coming. But that rally never happened. Because I was content tobook a nice gain instead of just letting the trade work, I missed one ofthe truly great short positions of the last decade or so. My trade hypoth-esis was the correct one and my initial timing was good, but I second-guessed myself. True, a lot of that was inexperience, but that is thewhole purpose of developing trading rules that work: to place controlson your behavior until you can trade with enough discipline to let prof-

its run.Rule #14, “Don’t second guess your winners,” is first cousin to Rule #11

and a critical part of letting profits run. Of the mistakes many tradersmake, the mistake of second-guessing themselves is the most costly. Notonly will they be out of the market when prices continue to advance favor-ably for their initial trade hypothesis, but often these same traders makethe most costly mistake of all by second guessing themselves: Trying to beon both sides of the market. If you want to watch your trading stake go upin smoke as fast as possible, I recommend you try to trade both sides of amarket that is developing a trend.

Because the temptation of unlimited profit potential is so strong,many traders attempt to trade from both the long side and the short sideof a market that has true potential in only one of those directions. This is acommon mistake to make after a market has made a hefty advance in onedirection, because we all know a correction is coming and it will be a bigone. For example, if you are long soybeans from the seasonal bottom atthe end of the year and on into the spring, and if the market has advanced80¢/BU up to planting, it is reasonable to expect a top may be in place ifthe acreage planted is higher than expected. It would not be uncommonfor sellers to come in and for holders of open longs to liquidate at leastsome of their positions. Under those trading conditions, a 30 to 40¢/BUdrop in price would not be uncommon, and that drop might take a weekor longer to play out. If you are holding a nice open-trade gain on openlongs, you might be tempted to liquidate and reverse with the intention ofreestablishing longs after the correction, taking a gain from the short sideas well.



The problem is, in this case, you might be shorting a bull market. Re-member, it is the blood of the shorts that have been paying the bulls. Youhave now placed yourself on the side of the market that has already

proven to be the losing side. Yes, a 40¢/BU correction is a lot of money,and yes, that correction would work against an open-trade profit. But therisk you are taking by second-guessing your original bullish hypothesis isthat you will not time your participation well. In most cases, the antici-pated correction will not happen exactly as expected, nor will it be pre-cisely a certain amount, if underlying bullish conditions remain. Ifconditions remain bullish for a change in trend, and that uptrend has an-other three months to go, you won’t know that for certain until later, butyour new short position is in serious jeopardy. If those bullish conditionsremain after a bearish fundamental is ignored or absorbed, it will onlytake one rally to take away a good portion of your previously closed gainand you won’t have a position of any kind once you liquidate your losingshorts. A $1.50/BU price change in favor of the bullish hypothesis goingforward might mean little or no gain to your account if you don’t haveyour original base longs still working—you were short for a time againstthe trend and you were flat for a time, waiting to reestablish your longsthat would have worked anyway.

All of this could have been avoided by holding to your original hypoth-esis and letting your positions work until that market was clearly overfrom the long side. By second-guessing yourself, you took money out ofyou own pocket when your hypothesis was the correct one.

Now, I’m not suggesting that you will see a $1.50/BU up-move in soy-beans every year. Obviously, seasonal tendencies in the grain complex aredifferent from year to year; I am not postulating that bullish or bearishtrades will play out as anticipated under all market conditions. I am sim-ply using an illustration. My intention is to show you that no matter how

you come to a conclusion that a market has potential in one direction overanother, you serve your self-interest best by staying with that hypothesisand not vacillating. You need to consider trading only from that side inmost cases, and you need to find a way to leave your initial position onlong enough for the potential you have found to develop fully. That couldtake time.

The psychology behind this rule is critical for your lasting success, be-cause following this rule helps you follow all the other rules for lettingprofits run. If you second-guess yourself and your trade hypothesis, mostlikely you will cut an open-trade profit short, you will not add to your win-ners, and you will not have a profit objective you are willing to wait for.When you second-guess yourself you lose the benefit of using multipletime frames and of course, your records show that your personal results

Don’t Second-Guess Your Winners 85


data remains inconclusive for true learning of your strengths and weak-nesses. At best, changing quickly from one hypothesis to another preventsyou from finding the truly profitable trades that make all the difference;and at worst, it prevents you from getting paid the highest return for therisk you are assuming. One reason short-time-frame traders never achievethe lasting success that long-term traders more often have is because theshort-time-frame trader is not holding to a perspective that pays the most:identifying a change in trend and sticking with it.

To make this rule work, you as a trader need to be prepared to makeadditional choices for the long-term health of your trading account. Toearn the highest rate of return possible, you need to prepare ahead of timecertain trading behaviors and be ready to apply them. When a trade hy-pothesis is working and your initial base position is showing a profit, beprepared to ask the question, “How far could this go?” If you are willing toconsider that your initial price objective may be only a small part of whatmight prove to be a huge move, you must be willing to consider enteringfrom the same side again very quickly if you liquidate. Perhaps adding tothe position as the market passes your objective is a better move. If youare remaining vigilant in your personal market study and your recordkeeping, perhaps you see that something is changing and your originaltrade hypothesis is more accurate than ever; in this case, holding at leastsome of your position is a better play.

This rule works for your best potential when you have the capacity tohold to your first conclusion and are willing to stay with it for as long as ittakes. When you look at some past market moves, trends that lasted foryears in some cases, there are always traders who were there and on theright side at the turns—when the risk was lowest and the profit potentialgreatest. Some were even there by accident. But as the trades developed,those very same traders chose to change their hypothesis for reasons oftheir own, either liquidating long before the full potential was realized oreven entering positions from the other side and suffering losses. By re-maining in the frame of mind not only that you can be positioned at theturns but also that you can hold those positions, add to them, and wait forthe trend to fully develop without taking yourself out of the game early,you will be in position to hit the home run. But if you let the short-termfluctuations or pullbacks convince you that the trade is no longer going towork, or convince you that the trend has failed, you are not trading the netorder flow or the market potential—you are merely trading your personalpoint of view. Your goal in making this rule work for you is to learn whatyou need to learn about your market first and be willing to give the marketas much time as it needs for that trade to develop.

By combining the essential elements of “letting profits run” into an ef-fective trade management technique, you will gain the confidence you



need to sit tight on a winning trade and let traders in the other time framescome to the same conclusion and add order flow in that direction; and youwill create the discipline required to hold for the objective. All the timethis is happening, you are watching for more clues that this is really thebeginning of a bigger development in the same direction. When you seethat potential fully, you can then add to the winner and easily wait for thenext objective.

Over time, as you practice holding winners and letting profits run, youwill learn that the markets are a very big place. There are times when thehugeness of the move won’t be seen at all by anyone at the start and only ahandful of traders will have positions on. Once that trend develops andbecomes clear to everyone, that power from the net order flow will pushthat trade farther than you might have initially expected. Remaining opento that possibility right from the start increases your probability for awindfall gain. If a change in trend is truly developing, those clues willshow, and you need to be open to the possibility that you were in the rightplace at the right time; now you need to run with it.

Traders who have the ability to let a profit run are always the traderswith an open mind to the possibility that anything can develop. Once theyare on the right side they are looking for clues that this position might go avery long way. They tend to stay with that potential until the market hassaid either yes or no, but they rarely second-guess their initial hypothesisfor the simple reason that it apparently was the correct one. Rather, theyask the question, “How right could this be?” If their initial trade hypothesisis the correct one, and it turns out to be the correct one for years, they willmost likely have some trades on all the time. But they made that choicebefore the trade was entered. Those traders took the point of view thatanything can develop, and if it does, and they are on the right side, theyare sticking with it.

Don’t Second-Guess Your Winners 87


PART IV

Trader Maxims


91

RULE #15

Know theLimits of

Your Analysis

Every ship at the bottom of the ocean has a set of

charts on it.

—Old nautical saying

When I first started trading in May 1986, the first book I read on themarkets was Chart Your Way to Stock Market Profits, by David L.Markstein (New York: Arco Publishing, 1972). I have since lost

the book and I couldn’t find it again searching the Web. I probably threw itout, now that I have a better grasp on what I am doing every day. Aboutthe only thing I remember about the book was how intoxicating it felt toread something for the first time that provided me with such a simple so-lution to my goal of getting rich in the markets. I was too uneducated(some would say naive) to understand that it wasn’t going to be that sim-ple. There were numerous books and services available for people inter-ested in trading equities, but there was very little data availablespecifically for traders interested in futures or options. The cash FOREXmarkets were the exclusive domain of banks and private investors, so thatmarket wasn’t even available. For me as a new trader, the best course ofaction was to actually go to work in the industry and learn the businessfrom the inside out. So I did.

After I began trading—and accumulating losses—I continued toravenously devour anything I could find on market analysis. At the time,the alleged science of technical analysis was still in its infancy. Most ofthe technical indicators that are used by traders today were just con-cepts. Commonly used indicators such as Williams %R, MACD, and the


commodity channel index (CCI) had not been developed or were not licensed to all the available charting services. Many indicators were formulas you had to compute manually and then physically mark the results on a paper chart. At the time, having a real-time data feed from the exchanges was very costly and required dedicated computerhardware. There was no online access to information like there is to-day, and you needed an actual broker available to place trades and re-port fills. All of what we take for granted today as a professional-level,online market presence literally had not been invented yet; and this wasonly 20 years ago. (As a side note, I actually met George Lane, the de-veloper of stochastics, at the Chicago Board of Trade just after I beganworking full-time in the markets in 1987. He was considered a god atthe time.)

I continued to read, study, chart, and trade for years, spending hugesums of money on real-time data feeds, books, audio courses, chartingservices, live seminars, and so on. During this educational experience, at

no time did any of these self-created gurus ever mention that the futuresand options markets were zero-sum transactions. The only exposure I ini-tially had to the concept of zero-sum transactions was when I passed mySeries III brokers exam. I didn’t know how critical that information wouldbe until after I had my first blowout. In fact, when I teach my “Psychologyof Trading” seminar today, there is always at least one person in the audi-ence who has been trading for years but has never even heard the termand has no clue what it means. The inherent nature of zero-sum transac-tions makes analysis of the markets a very different thing than the ana-lysts and chartists would have you believe.

During this part of my development as a trader I continued to havenet losses. I searched and searched for the cause of my losses, believing,like most novices do, that the problem must be at least in part due to howI was doing my analysis. What made this period so frustrating for me wasthat the root problem was exactly that—how I was doing my marketanalysis—but real analysis of the markets has very little to do with tech-nical analysis or technical indicators. Knowing that difference is whatmade all the education come together for me. You need to know that dif-ference as well, or your results will remain net losses, because zero-sumtransactions cannot be mathematically analyzed nor predicted with anycertainty. Proponents of technical analysis methods will have a field daywith that statement, but I am going to show you something that will helpyou understand that the limits of technical analysis, when properlyviewed in the context of zero-sum transactions, are the very thing thatmakes it valuable.

The very nature of zero-sum transactions means that exactly 50% ofexecuted contracts have profit potential. Once the net order flow has

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moved the traded price away from the executed entry, it is impossible forboth of the open positions to show a profit. Without advance knowledgeof the net order flow, your actual mathematical probability for a winningtrade once you have executed for your entry is 50%. Bear in mind, I am notusing any trading hypothesis, analysis, or previous support/resistance in-formation. I am merely stating the fact that once the market moves, youwill have either an open-trade profit or a loss at that point. We are not dis-cussing the market “coming back,” the potential to make a new yearlyhigh/low, chart formations that have probabilities, or anything else. I amsaying that from a mathematical point of view, it is impossible for every-body to be right.

The idea behind technical analysis is that by somehow combining ordividing previously traded prices, overlaying a type of constant algorithmto previously traded prices, comparing previously traded prices to someformula, and so on, you can thereby arrive at a number that the markethas a potential to reach, predict the market will change direction, or beconfident that it will continue in the same direction. The seduction of yourwill is now complete and you place yourself at risk.

But the market continues to move for the only reason that it will evermove—because of the net order flow. Most traders now believe that if youhave an open-trade loss after this mental dance of technical analysis hasbeen done, somehow the analysis was not done correctly—otherwise,they would have been on the other side or waited. This illusion is whatmost traders operate under for the entire life of their trading career. Themore firmly entrenched a trader is in this illusion, the greater amount ofstudy or analysis he will do or the greater amount of money he will spendtrying to develop a better technical approach.

The important bedrock understanding you as a trader need to haveabout technical analysis is that it is not predictive; it is historical. Techni-cal analysis cannot predict price action because it is mathematically im-possible for everybody to be right in the first place, and everyone has thesame technical analysis available to them.

A price chart with a 21-bar moving average and stochastics on mydesk is identical to your price chart with a 21-bar moving average and sto-chastics on your desk. If we both conclude the same thing—that this datapredicts a price rise, for example—and every other trader in the world us-ing that same technical analysis sees the same thing we have been taughtto glean from it, and we all decide to buy because we trust the analysis,the only way we can get into that market is if someone sells to us. What isthe seller using to conclude that the time to get in is also now but that themarket is poised to move lower? What is his analysis based on?

The really seductive part of this whole process is that if the trademakes a profit, the trader assumes the analysis works. That is the conclu-

Know the Limits of Your Analysis 93


sion most traders will come to. The only reason the trade worked is be-cause the net order flow was from that side, but the trader concludes itwas the analysis that found the trade. Once the analysis works one time,the trader extrapolates that to mean it will work all the time. If using theexact same analysis again results in a loss, the trader assumes the faultwas in how the analysis was done. In other words, the crystal ball wasn’tplugged in this time. But the trader is still convinced that he owns a crys-tal ball.

If you do your homework you will discover that any form of technicalanalysis has some level of probability of finding a winning trade. For themost part, all technical analysis or mathematical models developed forsystemized use have a success rate between 38% and 52% winning tradesbased on the predictive hypothesis used by the developer. That is no bet-ter than chance. If you flip a coin 100 times you will have 52% heads ortails, or some random bell curve distribution based on probability theory.In fact, the entire industry based on this predictive illusion of technicalanalysis is very proud to document to you the winning trade to losingtrade ratio of the system in question. If you want a real eye-opener, justcount how many of these high-tech, systemized approaches have win/lossratios lower than the 35% range, which is actually less than flipping a coin.What are these people thinking?

Since technical analysis will only help you 52% of the time at best,why would you trust it 100% of the time?

Answering that question and really thinking about what you are do-ing is the key to following this rule. You must know the limits of youranalysis and what the analysis is really saying in order to use it success-fully. In my opinion, the simplest way to effectively use technical analysisis to look at it from the loser’s point of view.

Proper analysis of your market starts with the understanding that notall of the participants are going to be winners. The loser is in there some-where and he must liquidate at some point. Looking at the market priceaction from the point of view that the loser is in there, thinking and trust-ing something that allows him to place himself at risk, puts you in a posi-tion to anticipate potential net order flow when it is about time for theloser to quit. Your best analysis is done by asking the question, “Where isthe loser?”

The last thing you want your analysis to do is attempt to predict priceaction. You want your analysis to disclose historical information. Youwant information that discloses where the loser is, what he is most likelythinking, and where he will most likely be forced to liquidate the losingtrade. You already know that the loser has trusted some form of analysis,he is using it to predict price action, and he can’t be right. Armed with thatpoint of view, you need to assess at what point a loser would come into

94 TRADER MAXIMS


the market and where he would most likely liquidate. All of your technicalanalysis is best used to help uncover where the loser is and what he ismost likely thinking in order to continually keep placing himself at risk.Your analysis is best used to help you understand what has already hap-

pened and then help you deduce what must happen next.This is a different process than predicting price action. The process of

critical deduction, intuition, and knowledge combined with the question“Where is the loser?” is not predictive. You really don’t need to answer thequestion, “Which price is coming next?” You need to answer the question“Where and when will the loser quit?”

Before we conclude this discussion on the limits and usefulness oftechnical analysis, I think it is best to make a few things clear so no one getsthe wrong impression. I am not saying that technical analysis is bad or thatit is without value. There are many parts of technical analysis that are veryuseful and should be part of a well-rounded trading methodology. I thinkyou would be best served in your use of technical analysis if you would nottrust it implicitly to find winning trades. I believe that it is best used in con-junction with sound knowledge of what ultimately drives prices.

Net order flow can only change if someone is certain enough that hewill make a winning trade and he is willing to initiate a position to find out.Regardless of all the little nuances that happen around the net order flowor the degree of probability one kind of analysis has versus another, thebottom line is that only a fraction of open contracts will be on the rightside of the price action long enough to have a profit. Technical analysis isdesigned to uncover this inequality, but charts cannot tell you what willhappen. Charts and analysis can only provide a detailed history of what hasalready happened. It is up to the trader doing the analysis to deduce whatis most likely to happen next from that historical information.

Know the Limits of Your Analysis 95


97

RULE #16

Trade withthe Trend

The trend is your friend.

—Edwin Lefèvre, Reminiscences

of a Stock Operator

Anyone who has traded for more than one day in his life knows thisrule. As a factor in managing risk/reward ratio and playing it smart,most traders attempt to trade with the trend currently in progress.

Identifying a trend in progress is rather easy. If we set aside all the otherparts of a trading approach, things like how to get positioned properly,limiting losses, adding to a winner, and so on, and focus on just this onerule for a moment, we have only one thing we need to be concerned with:the direction, or trend, of the market.

WHAT IS A TREND?

A trend is usually defined in the markets as a general direction that netprices are moving. There are three kinds of trends, and all of them can behighly profitable when traded properly. All three kinds of trends have a be-ginning and an end. Additionally, the end of one trend usually signals thestart of the next trend. I personally believe that identifying the end of atrend is the single most profitable trading tool you can develop. The end ofthe current trend is the best place to liquidate an open-trade winner


and/or initiate a new position at the beginning of the new trend, when therisk is lowest and the profit potential is greatest.

The three types of trends are uptrend, downtrend, and range. Obvi-ously, an uptrend, as shown in Figure 16.1, is a series of prices where thehigh prices keep getting higher and the low prices are marked higher, too.Figure 16.2 clearly shows a downtrend, while a range is illustrated in Fig-ure 16.3.

Making this rule work for you requires a willingness to identify what

is already happening and simply assume that it will continue for at leastthe time you are in at least one trade. You also need to decide whetheryour trading methodology will work for each kind of trend. Some system-ized approaches or technical methods are trend followers and some arebreakout or momentum identifiers. Breakout or momentum approachesare not good for initiating positions with an existing up or downtrend;they are not designed to remain in a market long enough for the trend toresume and create a profit. Breakout or momentum approaches are bestused when a market has been in a range for a period of time. When therange is over, that is usually signaled by a large move in one direction orthe other.

If you intend to trade with the prevailing trend as part of your trade

98 TRADER MAXIMS

FIGURE 16.1 Typical Uptrend Chart


Trade with the Trend 99

FIGURE 16.2 Typical Downtrend Chart

FIGURE 16.3 Typical Range Chart


method, make sure you know which trend your method is designed for.Systems designed for range trading will lose money on any other kind oftrend, because trading a range assumes a shorter time frame and often as-sumes you will use a close and reverse methodology. If you are not willingto be long from the bottom of the range and then short back down fromthe top, then a range trading system may not work as well for you.

No matter which trend you choose to trade, the common-sense psy-chology behind this rule is “Don’t argue with the market.” Figures 16.1through 16.3 all clearly indicate which prevailing trend is evident, andyou should be able to determine the right side for initiating a positionwithout a lot of argument. As a trader looking for long-term success, oneof the important disciplines to learn is that the market is always right.The market very clearly says what the prevailing trend is, and takingmoney from a market no matter which trend is evident does not require alot of effort, study, or work. It requires discipline. Once you are in posi-tion along with the prevailing trend, there is nothing to do but add to theposition as the trend continues. Regardless of your initial objective forliquidation, if the trend remains in place and a further price advance isdeveloping, there is nothing to do but add to the winning position untilthe trend is over.

Before we discuss clues to discovering the end of a trend, I would liketo discuss each trend individually. Each kind of trend has some unique un-derlying behavior that needs to be understood in order to take less riskwhen trading it.

UPTREND

An uptrend is the most difficult to trade successfully. Finding a market ata critical or significant low price does not insure that a bull market willever develop. But if it does, bull markets are actually aberrations and ex-ploited by professional traders as a short-term situation that provides ashort-selling opportunity. The more convinced the typical trader is that abull market is under way, the better the short-selling potential for the pro-fessional. It is no accident that most fortunes in futures and options havebeen made by short-selling.

When discussing bull markets in futures and options, it is important tonote that equities are not included in this discussion. Equities are invest-

ments, not speculation. The underlying reasons for a bull market instocks are almost never the reasons for a bull market in other markets.Equities are not zero-sum markets, so the forces that create price actionare different. Unlike the 50/50 relationship between long and short posi-

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tions in zero-sum markets, short interest in equities typically is nevermore than 5 to 8%, even in raging bear markets.

There are no bull and bear markets in FOREX, either. True, you maybe long or short one currency from the point of view of the other, but thatis a function of relative value, not bullish or bearish. Currencies are notmoney in the truest sense of the word. The currency markets have alwaysbeen subject to some stable store of value throughout history (such asgold), and only in the last 50 years or so has the stable store of value rela-tionship changed. All currencies devalue over time, regardless of whetherthey rise or fall faster against one another for a period of time. A bull mar-ket in currencies is not possible, even though one currency may gain valuebriefly against another.

If you intend to be long a market for a developing uptrend, you mustbe prepared to consider that a shorter-term trade. Bull markets attract alot of noise and people who normally would never be in that market. Forexample, in 1988 I traded the grain complex during the Midwest drought.At the height of the price advance, over half my customers buying grainshad never traded in any market before. Many had bought only becausethey saw it on the news every day and simply couldn’t pass up a suppos-edly sure thing. The entire bull market was over in four months, and thegrains haven’t traded those prices again since. Bull markets are exhaus-tive in nature and are often subject to manias, panics, and nonprofessionalparticipation, much more so than other trends.

As a developing trader, part of your best approach for trading an up-trend is the point of view that “All of this could be over tomorrow. There isno such thing as a bull market.” Always be hyper-vigilant on a long posi-tion when trading an uptrend. Bull markets make me nervous.

DOWNTREND

Trading in a downtrend is the most secure and profitable way to increaseyour account balance. Once the pressure comes on, that market could goa long way and be under downtrend for years and years. Contrary to up-trends, bear markets need very little to keep them going; hence the oldtrader’s phrase, “A bull has to eat every day but a bear only needs to eatonce in a while” (referring to news and additional new traders coming in).I say more about bear markets in Rule #24.

A downtrend always follows an uptrend. It is the nature of zero-sumtransaction markets that any bull market will be followed by an equal orgreater bear market. If your trading approach is to include short-selling,then any bull market needs to be closely monitored for the inevitable



change in trend that will occur. It is only a matter of time, and if you areprepared properly you will make an absolute fortune on the short side ifyou are willing to remain disciplined and add to that short over time. As Imentioned earlier, the grains have never traded back to the highs seenduring the bull market in the spring of 1988. A properly positioned shortwould still be making money years after the highs in June of that year. Ifyou want to really get serious about trading and you want to make thisrule work for you, look for an equal or greater number of downtrends inyour regular analysis and trade selection.

RANGE

Trading in a range is the easiest money available to you. There is a lowerrisk of being early on the buy or sell side, which could occur when themarket is in an uptrend or downtrend. No matter how you slice it, youcould buy a low market a little too early or sell a high market a little toosoon. In a range trade, the buying and selling points are already predeter-mined for you. Your only real question is whether the range is over themoment you execute one way or the other for the first time.

I have found that range is the most profitable trading opportunity forshort-term trading. A market typically will trade in an established rangethrough at least three or four attempts to seek a new higher or lower equi-librium. In other words, once the range is established, there is a very lowrisk of a breakout in either direction for usually two solid attempts fromthe buy side or the sell side of the range. You simply buy the lower 5% ofthe established range and sell the upper 5% of the established range. If youare aggressive you can close your longs and reverse, attempting to cap-ture both sides.

Range trades are more common in shorter time frames such as the120-minute or less. Almost all uptrends or downtrends experience periodsof range lasting from several hours to several weeks while continuing theoverall advance or decline. Some traders establish base positions on theuptrend or downtrend and then, when range is apparent, trade short-termfrom the same side until the overall trend resumes. Then they add to theopen trend-following position.

BENEFITS OF CLEARLY APPRAISING TREND

Uptrends, downtrends, and ranges occur with regular frequency, and eachoffers better money-making potential when it ends. Once an uptrend ends,

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it will be followed by a downtrend very quickly. A range at the end of anuptrend is less common than before the end of a downtrend. A range willend in a continuation of an uptrend or downtrend more often than not. Inother words, the prevailing bull or bear market usually continues a bit fur-ther once a range has been evident for a short time. When a downtrendends, it is usually followed by a range for some time. Very rarely does adowntrend end and an uptrend immediately begin, forming a “V” bottomat a significant low price. In most middle-priced markets, the process oftrend identification goes like this: range, resumption of uptrend/down-trend, range.

The end of an uptrend or downtrend is the most profitable time be-cause the risk is low and profit potential high just before prices reverseinto the change in trend. Identifying a change in trend from up to down (orvice versa) is easy in hindsight because the price chart will clearly showyou the directional change. But in most cases, if the event is about to hap-pen in a middle-priced market—a market that is not at a significant highor low, (such as a 10-year price level)—then there will be some period ofrange just before the turn. If volume and open interest have declined dur-ing this period of range at the end of an uptrend or downtrend, there is ahigh probability a reversal is in the works. See Figure 16.4.


FIGURE 16.4 Change in Trend: Uptrend Followed by Range prior to Downtrend.USD/CHF Cash Spot FOREX, April 17, 2005, to April 17, 2006. Courtesy of G.T.S. Charting.


The important thing to remember about this rule is that each of thethree potential trends available has unique characteristics. Developing asolid trading method is all about fitting your personal trading approachinto the most comfortable kind of trend for you. I personally have workedwith traders who, after learning enough about the market psychology andtheir personal psychology, have decided to only trade one kind of trendrather than try to trade all potential price action. As a matter of fact, thehighest performers have always been short-sellers working in downtrendsor the sell-side of ranges.

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105

RULE #17

Use EffectiveMoney

Management

Success does not depend upon having enough capi-

tal but in deploying it properly.

—Frank A. Taucher

Every trader at one time or another has made the mistake of im-proper equity allocation. By that I mean trading too large or toosmall, adding to a losing trade, cutting a profit short, or failing to

add to a winning trade. In reality, equity allocation is not a function oftrade management. It is a function of understanding who is taking risk andwho is using the market for what purpose. Very few traders have fully un-derstood the relationship between real risk and perceived risk. Evenfewer know that properly assuming risk to begin with is the key to build-ing a healthy balance.

Many books have been written on proper money management. Mostof them start with the premise that taking an unreasonable risk iswhere all the woe in your portfolio comes from. Many successful in-vestors have well-diversified portfolios and have various percentages inlow-risk, medium-risk, and high-risk investments. The underlying as-sumption is that the more risk you take, the worse your potential gainswill be. If you look deeper at the issue of money management, you dis-cover that the real problem is who is managing the wealth and whatthey are thinking.

I know many people who have what they consider to be well-diversifiedportfolios. They have 40% or so of their money in low-yield places like mu-nicipal bonds or U.S. debt. They have 30% or so of their money in places


like growth stocks or investment real estate. The rest is spread out be-tween things like start-up business ventures or cutting-edge opportunitieslike bio-tech or alternative energy stocks. Basically, as far as I can tell,they are content to preserve their capital and hope for the best. They don’twant a lot of risk.

All of these various “secure” or “less risky” investments boil down tosomeone else in control. If I buy a stock investment, for example, the po-tential growth to my capital investment is actually going to be determinedby how effective the management team of that particular company is. If itturns out that the management team is unresponsive to the underlyingbusiness climate, the potential for that company to continue growing mar-ket share (and stock value) diminishes. If I invest in some kind of bond,the interest rate depends on how long I leave that capital in someoneelse’s hands. If a city government wants to build a new highway and raisesthe cash from a bond sale, that city will make more money over time thanit will pay me in interest, and it may require me to keep the bond fordecades.

All of this is well understood by professional money managers, andthose individuals have mountains of data designed to maximize yield andminimize risk. They have huge amounts of capital allocated across asmany different market opportunities as possible and they pay the yield toyou, the investor (less any fees). As the investor, you must be content toreceive whatever gain that particular money manager’s skill set is capableof earning. The professional money manager is not a risk taker. He is arisk avoider.

For us as traders the game is completely different. We are looking toexploit some perceived opportunity when we see the current market priceas too high or too low relative to some other price we are expecting to seetrade down the road. We start from the premise that the risk is certainlyworth taking. But knowing the perfect price/time relationship to assumethat risk is the difficult part. In my view, we have this problem because wedon’t know that asset allocation and money management are for invest-

ments, not trading. Trading is about getting paid for a risk someone elsedoesn’t want to take.

If you study wealthy individuals who started with nothing, you willdiscover there is a common thread behind all of them. They all take con-trol of their finances and allocate resources differently than the averageperson. They assume risk others will not—and the lion’s share of profitsgoes to them. Most of the self-made wealthy people have discovered thatpeople will pay to avoid risk. This is also where the concept of other peo-

ple’s money comes into play. Without question, the proper use of your cap-ital will lead to using someone else’s capital, thereby creating leverage forthe risk taker. In the markets we call that margin. If you are trading crude

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oil, for example, the total contract value is much larger than the cash de-posit needed to control that contract. That crude oil is somewhere in theworld for the time you control it. Someone is willing to let the pricechange either for or against him, and one of those someones is a hedger.Knowing when hedgers are active in the market leads to knowing how toproperly allocate capital.

A hedger’s goal is to transfer risk to the speculator. You are the specu-lator. When the hedger feels it is time to transfer risk to you, it is time toallocate your capital and take the risk. Properly use of your capital beginswith accepting risk. Individual traders who hope to profit without assum-ing a lot of risk are setting themselves up for a trading disaster. Tradingthe markets cannot be done successfully unless you assume risk. Whensomeone who does not want the risk is active, you have a time/price rela-tionship that has a very good chance of being a place to assume risk. Thekey is understanding that low rates of return are paid to non–risk takers,and high rates of return are paid to risk takers.

Using our crude oil example, when a hedger sells into the market, thatparticular hedger sells crude oil because he believes a price decline is pos-sible, even likely. By using the markets to hedge he is saying, “I don’t wantto risk a price decline.” Who would be most likely to know if a price de-cline was possible? Wouldn’t that be someone in the business of selling

crude oil for a living? The moment the hedger becomes active, you have avery good clue that it is time to allocate capital and assume the risk thatthe hedger does not want. You now take your capital and leverage his

knowledge.Now, I am not saying that you should sell into the crude oil market

just because the hedgers are selling crude oil today. I am saying that prop-erly allocating your capital begins by knowing who does not want the riskin the market, and accepting that risk. In most cases, simply knowing theprice levels at which the hedgers say, “That’s enough” gives you the bestplace to begin using your capital. Effective money management beginswith assuming the right risk at the right time. The rest is academic.

Why is this point of view the cornerstone to effective money manage-ment? Because the markets are designed for the hedger and not the spec-ulator. The speculator is attempting to profit from a perception of pricepotential. The hedger is using actual prices. In most cases the hedger islooking for a change in price when he participates. If the price changedoes not occur he is not harmed. If the price change does occur, he is pro-tected and he provided you the opportunity to benefit from that change. Inmost cases, hedging activity will stop a price advance or decline, or atleast delay it. Knowing when and where hedgers are active provides im-portant clues for when it is time for you to take the actual risk and thebenefit your account.

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The perception of risk is what most money management concerns it-self with and this perception of risk is what most traders focus on. Theywant to play but they don’t want to pay. There is only one risk in themarket: that you may be on the wrong side of the net order flow. You canperceive that situation immediately by the very next traded price, so per-ception of risk is not really a concern—except for the trader who is igno-rant of or unwilling to accept the actual net order flow. What you want toavoid is executing for your initial position in a place that is of no interestto the person who ultimately receives the best benefit from the markets.You do not want to buy and sell from other speculators. You want to ei-ther buy or sell with the hedger or against the hedger; but you want toavoid participating against other speculators for the most part.

Once you are accepting the risk others do not want, and the market ismoving favorably for your initial position, the rest of proper money man-agement comes into play, but this is only valuable because you still haveyour original money to begin with. If you have been trading for a reason-able amount of time and a reasonable number of trades but your equity islower than your starting balance, the only thing you need to discover ishow to get on the right side of the net order flow more often. One valuableclue is knowing when hedgers are active, because they will execute toavoid risk only at price areas that are actually important. The fact thatmost speculators are losers means that a certain amount of them will beavailable for the hedger to square off with. Who is more likely to win, JohnQ. Public or Cargill, when both are trading in the wheat market?

Once you have a winning position working, you must allocate moreresources to the winner. The four basic rules for money management atthat point are as follows:

1. Roll protective stops to the break-even point.

2. Purchase options to lock profits.

3. Add to the winner on pullbacks.

4. Scale out when hedgers from the other side become active.

I have found that a 1.5% equity risk on initiation of the position willkeep you in the game until you have found the winner and have a lead onthe trade. Using options to lock profits will free up equity to add to thewinner. When hedgers from the other side are active, the limits to theplaying field are established and liquidating some or all of the position isadvisable.

Now, I know most traders were expecting this rule to be a discussionof ratios, percents, stop placement, and so on. In the Introduction Ipointed out that making the rules work depends on understanding the

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psychology behind the rules and adapting that psychology to your per-sonal trading approach. The psychology behind using effective moneymanagement is first and foremost preserving your capital until you findthe winning trade. That’s easy enough; don’t risk more than about 1.5% ofyour starting balance on any one trade. Once you have a lead on the win-ner, you add to it and let it work. You liquidate when the net order flowdries up in that direction. You are looking to initiate when the net orderflow is set to change, and you are looking to liquidate when it changesagain. In between those two points you are looking to add to your winnerand lower your open-trade risk, either by rolling stops or buying optionsagainst your futures.

The best way to effectively manage your equity is to look for the riskno one else wants to begin with. That is usually a price level that is of in-terest to hedgers. The rest is common sense.

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111

RULE #18

KnowYour Ratios

How did I get rich? Well, I sold apples to start. I

bought a dozen apples wholesale for 50¢, polished

them real nice and sold them for 10¢ a piece. I kept

at it until I had well over $3,000 in profits. Then

my uncle died and left me $1.4 million.

—Henny Youngman, comedian

Every business has ratios. Every business has expenses and in-comes. Every business has market share, and every business hasprofit and loss opportunities. Trading is a business just like any

other, and part of your long-term success as a trader will come fromknowing exactly what your business balance sheet looks like. You mustknow your expenses and incomes, you must know your market share,and you must know your profit or loss relationships. You must knowyour ratios.

Ratios provide important clues to the actual performance of yourtrading. When I teach my “Psychology of Trading” seminar, it still amazesme that some traders have no details or printed records of their recenttrade results to show me. They cannot tell me what their performance is.These traders have only one piece of information available: the balance intheir trading account. That would be like running a corner bakery withonly one piece of information each day: your checking account balance.No knowledge of your expenses, your utilities, cost of raw materials,profit margin on a loaf of bread—nothing. Imagine running a business that


way. Most traders are running their trading business in exactly that man-ner. They have few or no records with which to get the true picture of howwell their business is performing.

Accurate record keeping and regular calculation of your ratios willprovide you with important information that will give you several solidbenefits. First, by knowing your actual performance from day to day youwill see more clearly how well you are following the rules you have cre-ated for yourself. Next, knowing your performance ratios gives you cluesas to what areas of your daily trade presence need to improve. Last, andprobably the most important information, you will have more data avail-able when you are about to make a serious mistake. Knowing the perfor-mance you are creating in real time creates a sound understanding ofwhat you need to do from that point forward. No trader gets to be at thetop of his game without regular and critical review of his moment-to-mo-ment performance.

Every trader has distinct parts of his trade approach that requiremore focus than others. In my case, I am subject to a tendency to over-trade. I need to critically review my daily execution regularly because ifI am not careful I will easily break discipline in this area. I have noproblem holding a winner. So for me, a regular assessment of my execu-tion records is very helpful because overtrading usually results inlosses. My records have provided clues when I am about to start over-trading, and more often than not I can head that off at the pass. In aworst-case scenario, I have a rule that I have learned is a critical part ofmy discipline, and I follow it every day. I developed that rule because Idiscovered my tendency to overtrade by critically examining my traderecords regularly.

Once you have disciplined yourself to keep accurate records, youneed to begin calculating your ratios. Regardless of how you want to sliceit, because we operate in an arena that is subject to a degree of uncer-tainty, a portion of our net results is a function of probabilities. We cannotknow in advance with absolute certainty that we will be on the right sideof the net order flow. Once we execute, we are going to have a gain or aloss. A portion of those results will be due to chance, either for or againstour account balance. If we are maintaining a strong market focus and asolid level of discipline we can tip that percentage in our favor. The magicnumbers are 42% winning trades to losing trades combined, with a 2:1profit-to-loss ratio. These numbers are a factor of the probability of ruin

matrix, illustrated in Figure 18.1.The probability of ruin matrix is a calculation based on several pieces

of data. First, it assumes 100 events; in this case that would be 100 trades.Next, it defines ruin as a 50% drawdown from starting equity. Last, it as-sumes that the methodology used to initiate each event is always the same

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in every event; in other words, each trade done during the 100 trades inthe sample set is executed for exactly the same reason.

According to this matrix, if you do 100 trades, and have 42% winners,and pull two dollars out for every dollar you give back, your probability ofruin is a little less than 14%. If you calculate the numbers yourself you willfind that (42 � 2) – (58 � 1) actually yields a profit of $26, but the ruin ma-trix is using the full scope of probability theory. That includes the possibil-ity that all the losing trades will come in the first 58 executions, or enoughof them that your equity draws down 50% before the sample set of 100trades is complete.

Notice that a high percentage of winning trades is not an indicationthat you will make money net in your account. Someone who has 55%winning trades to losing trades has a worse risk of ruin if he wins aboutthe same amount as he loses every time. It actually is a better probabil-ity for your account if you have fewer winning trades but hold thosewinners for a higher profit/loss ratio. Of course, the best of all worlds isto be in the far right side of the matrix. A trader with 60% or more win-ning trades and only a slightly better profit/loss ratio than 1:1 has no

chance of ruin.Something else that is astounding when you think this through is that

this calculation is based on only 100 events in a sample set. Flipping a coinand predicting heads versus tails will be a 52% ratio. When the matrix iscalculated for a higher sample set, the percent probability goes down for atrading system but remains the same for flipping coins. That means that if

Know Your Ratios 113

FIGURE 18.1 Probability of Ruin MatrixRuin is defined as a 50 percent drawdown from starting equity.


you did 1,000 trades with a 42% winning trade ratio and a 2:1 profit/loss ra-tio, the probability drops to less than 8%. The more consistent you are thebetter you do, even if your ability to pick winning trades is less thanchance. This is where “black box” or systems traders have their successlevels. They really are not in the business of picking winning trades; theyare in the business of holding winners and remaining completely consis-tent in how they select trades.

In order to exploit the probability of ruin matrix for your personaltrading you need to know where you fall to begin with. I would suggestyou go back and review the last 100 trades you did and calculate your ra-tios. Once you have that knowledge, you can begin to develop changes toyour approach in order to exploit your trading strengths and minimizeyour trading weaknesses. If you discover that you have a high ratio of win-ning trades to losing trades, you simply need to develop the skill of hold-ing your winners longer. Perhaps that means waiting 24 more hoursbefore liquidating. Maybe you have a low percentage of winners but youare regularly taking two or three dollars out for every one lost. This couldindicate that you need to improve your entry timing a bit. Sometimes itmeans you are running your initial protective stop-loss order too close toyour entry; maybe a wider stop will help you find a winner a bit better. Ofcourse, the flip side to that is you will need to trade a smaller position, butyou get the idea.

The information you compile from your record keeping can provideyou with all sorts of information to improve these ratios. One trader Iworked with discovered that he had a very high percentage of winningtrades to losing trades on Monday through Wednesday each week but thathis ratio dropped on Thursday and Friday. He made a new rule for himself:If he was not up by a certain amount of profit by Wednesday afternoon, hewould quit for the week. If his equity dropped at all on a Thursday or a Fri-day, he would not give back more than a certain percent of his Mondaythrough Wednesday profits. He really never improved any other part of hisapproach with that knowledge. He simply discovered that he was great tostart the week but he had a tendency for losses later in the week. Armedwith knowledge of his personal trade performance, he improved his ratiosto the far right of the matrix.

If you think about being in any business there is a correlation betweensuccess and the information available. Some businesses are closed onweekends. They have learned from experience that Saturdays and Sun-days cost more than they bring in. Other businesses don’t need a store-front. Every business has parts that can be improved and things that needto be done more often to increase the success potential.

In the trading environment, there are parts of what we do every daythat will not put money in our trading account. There are things that will

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put money into our account easily and things that increase the potentialthat money will go away. By keeping very detailed and accurate recordsof your actual performance, you can calculate how well you are doingnet. You need to know what you are really doing well and what needs tobe improved. Because trading is what it is and a certain amount of ournet results is not in our control, we need data about our net results tohelp us change what is in our control. Knowing our ratios will keep uson track and show us where we need to develop additional controls onour behavior.

Always remember, the winning numbers are 42% won/loss ratio and a2:1 profit/loss ratio. I also recommend including your commissions andfees in your profit/loss ratio. They are part of your expense picture, so youneed to account for them.

Know Your Ratios 115


117

RULE #19

Know Whento Take a Break

When things are at their darkest, pal, it’s a brave

man that can kick back and party.

—Dennis Quaid, as Lt. Tuck Pendleton in Innerspace

One of the hardest things for new traders to do is to appreciate thatthe markets aren’t going anywhere. The worldwide evolution of fi-nancial markets is just like the evolutionary process evident in any

growth. Biological life-forms mutate and change, weather patterns de-velop and change, technology develops and replaces older technology;anything where you can find some sort of a growth pattern will mostlikely continue to develop and change. I think it is a safe bet that the cur-rent business and economic climate will be included in that process ofchange and development. What is almost certain is that financial marketswon’t take a step backward or cease to exist. The markets aren’t goinganywhere.

Most traders would agree with this point of view, but that is wherethey stop. It is easy to say that we know the markets will be here tomor-row and most likely for as long as humans live here, but it is quite an-other to remove yourself from the trading environment and simply go dosomething else for a while. Many traders have a hard time doing that.Most traders feel a tremendous sense of loss if they are unable to remainconnected to the market almost continually; they don’t want to miss thatcritical piece of news or that perfect trade. Many traders will literally stayawake for days at a time, trading as close to 24 hours around the clock as


they can. If the particular market they trade is closed until the next day,these traders feel compelled to analyze their positions, select multipleopportunities for the next trading session, or pore endlessly over marketcommentary.

As a group, traders have an almost manic obsession with their mar-ket and the profit potential they perceive to be available every day. Forthese individuals to stop trading, even for just one day, is a huge chal-lenge. Just look at the proliferation of portable, handheld trading inter-faces offering real-time execution. What opportunity could be so grosslyoverwhelming that I can’t afford to ride the bus for 15 minutes because Imight lose a profit?

All of this voluminous market data and all of the state-of-the-arttrading vehicles have evolved over time as a method of either makingsense of the madness or exploiting an ever more esoteric opportunity re-lated to the underlying fact that everything is changing and it will

never stop. If you want to, you can trade options on options, you cantrade pollution futures, you can trade electricity, and you can trade in-dexes on indexes; plus you can get real-time data on a palm computerwhile you are riding in a cab on the way to your daughter’s recital. Don’tforget your cell phone in case you have to call one of your many brokersand get your fills on your trades done in Asia or Europe last night (orwas it this morning?).

This is insanity.None of this super-connectivity or mobility will ever help any trader

make better trades or maximize his potential. I want to remind everyonethat the current state of evolution and financial specialization has not im-proved the trading environment enough to make more losers into winnersand more winners into bigger winners. Financial evolution is spinning outof control as we start the twenty-first century.

We need to remember that trading is not a science—it is an art form.Science does not make good art; that is why it is science. As a trader whowants to develop and maintain his edge for optimal performance and max-imum profits, you would be wise to take a step back and focus on what itis that really creates your profits. Your thinking creates your opportuni-ties, and if your thinking suffers, so does your opportunity.

I am of the opinion that trading is an intensely personal and subjectiveexperience. No two traders will ever see the market in exactly the sameway. No two traders will ever position themselves exactly the same way.No two traders will focus on the same information in exactly the sameway, and no two traders will ever come to the same conclusion aboutprice action. The only thing any two traders have in common is the factthat they buy and sell in the same place. It is because of this personal and

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subjective nature of the trading environment that the issue of knowingwhen to take a break is so crucial. The moment your thinking stops beingyour best thinking possible, your performance starts to slip.

If you observe any top performer in any field, you will probably noticea few things. First, they play their game their way. If they are in business,for example, they do things a certain way and they seldom move too faraway from that baseline activity. If they do change something they are do-ing in a particular way, they will have a very sound, well-thought-out rea-son. Next, they know what is important to make a profit and guard thatpotential in as many ways as possible. It really doesn’t matter what theprofit potential is or how it is realized, they know what will work and theyknow that they know. As traders, we do the same things.

But many top performers in other fields remember one more thing.They see life as a whole. They are interested in balance. They know thatlife is made up of many different things and that business is just one ofthem. In fact, they will tell you the reason they are in business the waythey are is to enjoy the various other parts of life more completely, andthat those things create more energy for them to work better. Business ismore of a means than an end for those top performers. If you look at thelives of top-performing athletes, you will notice that while some things aredifferent, there is a baseline that is very similar. They train regularly tostay in physical condition, they are disciplined about things like what theyeat or drink, they practice their game to stay on edge, and, most impor-tant, they know when to rest.

In almost any other profession there is a range of performanceacross all participants. Not everyone in a profession is a top performer,but in most professions you can earn a paycheck without being a top per-former. In trading, if you are not a top performer, you most likely will suf-fer losses. It is wise to remember that you are not competing againstother traders. You are competing against yourself. If you are not at thetop of your game when you play, the probability that you will beat your-self increases.

Due to the subjective and personal nature of trading, part of a strongdaily market presence must include proper rest. By that I don’t mean justa good night’s sleep, although that goes without saying. I mean you shouldtake time to recharge your mental batteries. Only you can determine whatthat means for you personally, but you need to make regular time to getaway from the markets and rest. While you are doing whatever it is thatworks for you, consider maybe that would also include no access to themarkets as well. Perhaps part of your trade plan would be a regularweekly, monthly, or quarterly time for something else, and that includesleaving your laptop at home.

Know When to Take a Break 119


For me personally, I discovered that regular time away from the mar-kets allowed me to relax and take a fresh perspective on things. I usuallyinclude a long four-day weekend every two or three months. If I have beendoing well enough I might make it an out-of-town trip, but I always take afew days to recharge. I have a lot of hobbies that I try to enjoy more often,like building model airplanes. All of these little and larger ways of gettingaway from the markets does one very important thing: It frees my thinkingand preserves a sense of balance. I discovered that trading, although veryexciting and interesting, cannot be done to my optimum performance if Iam not properly balanced. There is more to life than what we do for a liv-ing, no matter where we fall on the scale of success.

If you have a spouse or children, a sense of balance is even morecritical. Many marriages have suffered when one spouse or the othergets so involved with what they do to earn income that there is no timeor energy to care for what really matters—our relationships, family, andphysical health. Don’t be one of those traders who climb the ladder ofsuccess only to find that it was leaning against the wrong wall. Show re-spect for your personal state of mind and the emotional health of thosearound you by properly balancing the intense world of successful trad-ing with the infinitely more valuable world of people and personalhealth. No truly successful person will allow his life to fall out of bal-ance. Trading can require more creativity, passion, commitment, andenergy than most professions; trading also has the potential to leavenothing left at the end of the day for anything else. Part of a well-roundedmarket presence is doing something regularly that preserves your senseof balance.

Daily exercise is a great way to keep your sense of balance. Taking atleast one day on the weekend to do something that requires little or nothinking is another great way to remain balanced—something like takingthe kids to the zoo or a ball game. Planning a vacation at least once a yearfor more than just a day or two is another great way to recharge. Person-ally, I take the last two weeks of the year off for the holidays. Anything re-lated to the markets I leave at the office and I head to the islands to dosome sailing. I come back completely recharged and ready to tackle thenext year’s opportunities.

I’m not saying that these things will work for you, but there are doubt-less things that you personally enjoy very much that are often excludedfrom your life due to the pressures of trading. Doing those things regularlywhile disconnecting from the markets will help keep your head clear. Youwon’t be run down, tired, lacking energy, burned out, or juggling too manyballs in the air when the right opportunity comes along. Also, you willhave the mental resources free to manage those trades better, and you willsee more of them.

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The important thing to remember is that this rule is about improving

your performance. You really don’t need to trade every day. You aren’t go-ing to miss anything. The markets will never end and they will be herewhen you are back from getting tuned up again. You aren’t going to missanything so spectacular that a game of tennis will ruin your whole year.When you feel your performance start to slip a bit, take some time to stepback, turn off the noise, and get balanced again.

The trader who tries to do it all, all the time, is the one who will makea mistake. Don’t be that trader. Know when to take a break.

Know When to Take a Break 121


123

RULE #20

Don’t Tradethe News

A danger foreseen is half avoided.

—Thomas Fuller, Forbes Thoughts

on Opportunity

One of the more interesting phenomena related to price action is the relationship between news (fundamentals) and a trader’sparticipation. There is an old trader saying that you must have

heard at one point: “Buy the rumor, sell the fact.” This rule developedfrom observations made by traders over the years, and it has evolved intoa more complex kind of timing tool that I call “Don’t trade the news.”

The psychology behind this rule is not very complex at all. Nor isthis rule supposed to encourage traders to ignore fundamentals. Rather,there is a unique relationship between news and timing that makes par-ticipating in the market because of the news very deadly to your equity.Stop again and think through the issue of net order flow, open trades,and traders who want to get into or out of a position. Remember alsothat not everyone in the market can have a profit, due to the nature ofzero-sum trading. As we discussed before, you cannot profit unless youare on the right side of the net order flow. Why does anyone open a po-sition? Because they expect to make money from a perception theyhave about price potential. When the perception is acted on, the traderexecutes. When learning to use this rule, it is this perception that is ourconcern.

Let’s use a very simple illustration to see the value of this rule. Let’ssuppose it is early October of the year and the orange juice crop is about


to be harvested. October happens to be the height of the hurricane sea-son as well. On Monday of this hypothetical first week, weather forecastersalert the media that out in the mid-Atlantic Ocean a tropical depressionis brewing into a hurricane. The expected path of this hurricane includesthe potential for a direct pass over the heart of the Florida Peninsula—directly through the center of the orange belt, where two-thirds of theU.S. consumption is grown. Orange juice futures begin to climb in priceas traders speculate that the hurricane might severely damage the orangebelt or even destroy this year’s crop. Some traders wait to see how thisdevelops.

As Monday turns into Tuesday, then Wednesday, it becomes more andmore certain that by Saturday morning, this hurricane will come ashore as aCategory 5 storm right down the center of the orange belt. Orange juice fu-tures continue to climb. On Thursday the weather center declares there is a95% chance that this storm will pass through the orange belt. By the closingbell on Friday, orange juice futures are locked limit up and, to make mattersworse, the market won’t open for two days—not until after the hurricanehas blown away the orange crop on Saturday morning. The pool of unfilledbuy orders continues to grow until the end of the day as speculators try toget in on what is a certain higher potential for the following week.

A seasoned trader knows exactly how this plays out, but let’s just fast-forward to Monday’s open. As the news reports come in from the Floridaorange belt Saturday night and Sunday morning, the devastation is justtremendous. Not only have people lost their homes, businesses, evenloved ones, but the orange belt is estimated to have lost at least half of thisyear’s crop. As soon as the phones are open on Monday morning, the poolof buy orders continues to grow with traders just absolutely certain thatthey won’t see another glass of orange juice on their kitchen table formonths. The market is called limit up on the open.

The bell is rung and yes, the market opens limit up, but then starts trad-ing. It takes about an hour, but by that time the pool of market orders on thebuy side has been absorbed by the willing sellers. Slowly the market startsto quietly tick lower. Suddenly the market breaks. By the end of the day, theorange juice market is locked limit down and the Monday buyers can’t getout of their longs. The market is called limit down on the open Tuesday.

What happened? After all, the orange juice crop is gone!

But that’s not the point. The point is that people were trading thenews—or rather their perception of the news. The even better question is,who were the willing sellers?

The willing sellers are the same buyers who bought the market onMonday a week ago. They bought the rumor. By the time the rumor became a fact, the move had already happened and, in fact, it was the higher price action before the actual fundamental event that con-

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vinced the late buyer to buy. His perception was that orange juice washeaded even higher and he waited until he was absolutely certain. Theprofessional trader was following the rule; the amateur trader was trad-

ing the news.It is important to note that traders are smarter now than they were 20

years ago, technical analysis is more sophisticated, and trader knowledgeis greater. Even the most novice trader today has access to informationand trade help that professional pit traders didn’t have 20 years ago. Themarkets get smarter every year. Most novice traders know or have heardthe rule “Buy the rumor, sell the fact.” The difficulty is in separating rumorfrom fact—knowing what fundamental is being closely watched by themarket this week and how susceptible that market is to unexpected newscausing a panic.

In my view, the kind of situation described in this hypothetical orangejuice market probably has gone the way of the dinosaur. Most marketswouldn’t react in that way to most of the unexpected fundamentals thatmight drive trader perception. The point is that news and the perception

of news are what create some traders’ urge to action. When the news is re-leased, these traders form an opinion as to what the news means—theydecided it is either bullish or bearish, right now for them personally. Theythen execute and, more often than not, their open position is on the wrongside of the net order flow.

The maxim “Don’t trade the news” is about waiting until the panic/perception of less-informed/less-skilled traders have placed themselves atrisk. The unskilled trader makes that choice because he has formed anequal relationship in his mind between fundamentals and prices. Thistrader believes that the prices will advance or decline because of some-thing. The major element missing in this thinking is, of course, the rela-tionship between net order flow and a losing position. If a trader placeshimself on the wrong side of the net order flow, the reason for being thereis not a critical part of the trade. The reason used by the individual traderto get in a market has little or nothing to do with that market’s true poten-tial to move.

The problem with trading because of the news is that by the time afundamental news item is released, traders have already positionedthemselves, and the winning traders have only done that from their un-derstanding of the net order flow. If, for example, the news is bullish,the winning trader who is already long liquidates his long by selling tothe new trader who is initiating a long because of the news. The bullishpotential created by the news is absorbed by the trader liquidating intothe news. This is why any fundamental news release is almost alwaysfollowed by at least some opposite trade pressure shortly thereafter. Inthis illustration, the market has now run out of buyers. As the longs

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from under the market continue to liquidate and/or new sellers come in,they are competing for a smaller group of fewer and fewer new buyers.Once those late buyers are in, the market has nowhere to go but lower.The market has gone south on a bullish piece of news.

This potential is always there and is almost always certain if the newsis a regular report or a weekly release of some kind. There is more of achance that better-informed traders will open positions prior to the re-lease, and that once the news is actually released, the remaining traderswho execute because of that news are used by the winners to liquidatetheir winning positions.

Obviously, trading is not that cut-and-dried. There are times whenmarkets don’t move countertrend on the news, unexpected things causepeople to panic, or a market breaks out huge on a news story. I am notsuggesting that you should fade the news when you trade. I am suggestingthat a market is more indefinable just ahead of and just after a fundamen-tal news event, expected or not. Your best course of action to reduce yourrisk exposure is to not trade the news.

I find that the best way to help define market price action when the newsis actively influencing traders is to remember a few basic things. First, if youdon’t have a lead on the market, don’t trade ahead of the news or after thenews for at least one hour. Give things time to settle down a bit. Ahead of thenews, the price range will be very tight anyway, and after the news the initialrush of panicky traders will be washed out. Two-sided violent trade is usu-ally the case for the first hour or so after news is released. If the market runsaway in one direction, and it was the direction you wanted, you will just haveto wait for the pullback that is certain to come. Don’t chase the market. Youwon’t be perfectly positioned in any market anyway. Let things settle downbefore acting so you are not the trader getting whipsawed.

Second, the news is always factored in. No matter what the report,news, or economic numbers may be when released, every trader has al-ready decided what it means for them and how they will behave. Everytrader has decided that if the news is one thing, they will do such-and-such; if the news is another thing, they will do something else. Sometraders are in already with a lead, and if the news is such-and-such theywill liquidate; if it is something else, they will add to the position. Allnews, numbers, or reports are already in the market.

Last, the news can only be one of three things. The news, reports, ornumbers can only be

1. As expected

2. Better than expected

3. Worse than expected

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Once the news is out, traders will behave not according to the news,but according to their perception that the news was either better than,worse than, or as expected. Once they execute from that perception, themarket has order flow. How the market behaves with that order flow is aclue to the market’s real nature, not the market’s expected nature.

As an example, if a piece of news is due Thursday, is forecast to bebullish, and prices have advanced higher since Monday, but the actualnews released is worse than expected (bearish), whatever the marketdoes next is a great clue moving forward. If the market just takes offhigher, what does that tell you? If the market just sits there, what doesthat tell you? If the market breaks hard but rallies back in 20 minutes,what does that tell you?

The point is simply that observing the market’s actual behavior post-news gives the clearest indication of how traders are currently positioned,how nervous or confident they might be, and how willing they are to exe-cute. The one constant is that the trader who is making his choice to exe-cute in or out of the market, and basing that choice on the news itself andnot on the net order flow, is usually in the wrong spot. Don’t trade along-side that poorly positioned trader. Let him get out of the way first.

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129

RULE #21

Don’tTake Tips

Tips! How people want tips! They crave not only to

get them but to give them. There is greed involved,

and vanity. It is very amusing, at times, to watch

really intelligent people fish for them. And the tip-

giver need not hesitate about the quality, for the

tip-seeker is not really after good tips, but after

any tip.

—Edwin Lefèvre, Reminiscences of

a Stock Operator

One of my earliest trading experiences involved taking a tip. Itwas the early 1980s, and the tip was to buy silver and this wasthe early 1980s. If you have no knowledge of the attempted

corner in the silver market by the Hunt Brothers, I would suggest youtake a few extra minutes when you have time and look up the details; it is a fascinating story. For me personally it is more than a fascinatingstory because somewhere in the world, there is someone who has my $500.

I was a sophomore in college and I had a few bucks saved. I was sit-ting in class before the bell and one of my classmates was extolling theprofit potential in the silver market. As it turns out, he was from a familyon the wealthier side and apparently his father had made a killing in thesilver market. Maybe it was silver that was paying his tuition. I decided tohead over to the local jewelry store and ask about buying some silver. Icarried $500 worth of silver bullion home one afternoon. That silver lost80% of its value within a year.


I didn’t consider it a trade; I was not a trader at that point. I had noidea how investments, trading, or the markets worked yet. I simplybought into the story that silver was going to trade higher. I neverthought for a moment about what creates prices, who told me the data,or whether it was true. I just listened to the common sense of the argu-ment and went with it.

The whole experience became part of the catalyst to become atrader when I learned about silver futures. I discovered someone couldbe short. As my silver bullion declined in value, someone else was get-ting rich. Wow!

When we choose to listen to a tipster, the problem is not the informa-tion. The problem is not the quality of the stock or commodity market. Theproblem is not even whether the tip is wrong. The problem is within us astraders. When we fail to do our own homework and let someone else’sthinking become our guide, our results will never be any better than thethinking of the tipster. It doesn’t matter if the tip is a winner or how per-suasive the tipster is. When we let someone else do our thinking for us, werun the risk that the quality of that thinking is nowhere near accurate forthe market in question. The problem is in failing to think—not in the tip.

No matter how you choose to participate in the markets, you are ulti-mately responsible. When you finally decide that now is the time to exe-cute, it is your money at risk. If you have a gain or a loss, the credit ordebit is assigned to your account, no one else’s. Why would you let some-one else determine your results?

The problem with tips is not the data, because that data is really thesame for any point of view. No matter what conclusion you come to, therewill always be another point of view that is created from the exact same setof data. If you and I both compile all the data available in the meat complexand compare it to the technical picture the charts have at that moment, youmay come to a bearish conclusion while I come to a bullish conclusion. Theimportant thing is that neither conclusion matters to make a profit. Theonly thing that matters is being on the right side of the net order flow. Ifyour analysis helps you come to a conclusion and it happens to be the cor-rect side of the order flow, money will flow into your account. If your con-clusion is not the correct one, money will leave the account. In either case,putting your account balance at risk without knowing for certain what thepotential is for the underlying net order flow is simply reckless. When youtake a tip, you are increasing your risk because you are accepting the re-sponsibility for a loss without the corresponding knowledge of the market’sunderlying potential. Taking a tip is really just gambling with your money.

If you think about it, any analysis or market data that you make avail-able for your use is actually a sort of tip. When you use a technical indica-tor like MACD, for instance, you are placing your equity under the

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thinking process of Howard Abell, the developer of the MACD indicator.Personally, I like Howard. I have attended his workshops and read hisbooks, and I think he is a very sharp guy. But I also know that the MACDindicator is a mathematical formula that Howard developed. Howardknows that formula best and he will most likely be able to use that indica-tor better than I ever could because I don’t understand the thinking be-hind it like he does. How can I use Howard’s brain to trade my money?

If technical analysis is a sort of tip, and whispers overheard in theCBOT men’s room are tips, and government reports are tips, and articlesin trade journals are tips; where is the real data to trade with?

It’s inside your head. No matter what you read, study, or absorb, youpersonally have to choose the time to execute. The moment you pass fromthinking for yourself to trusting something outside of yourself, you aretaking a tip. If you trust technical or fundamental analysis past a certainpoint, charts then become a tipster for you. If you compile reams of dataand economic fundamentals, crunch those numbers according to someformula, and trade on that data, then government reports are your tipster.If you go to a psychic and ask to see the future waiting ahead in the meatcomplex, you are definitely taking a tip.

I think we as traders are susceptible to tips because we really wouldlike to believe that there is just one more piece of data that will disclosewhere the winning trade is. We desperately want to feel like we have cov-ered every possible piece of information and haven’t left anything out. Wehave really done our homework and no stone was left unturned. Yet so-and-so said . . .

In my view, the psychology behind this rule is really twofold. First, itprevents us from putting ourselves at a needless risk or trading for rea-sons that are not our own. We need to focus on market structure and tradefrom a sense of discipline, not gamble and hope someone else is right.Second, we need to constantly remind ourselves that our account balanceis ultimately our responsibility and we are fully in control when we exe-cute. Nothing determines our results except our actions, and those ac-tions need to be well thought out, proactive, and in harmony with themarket we trade, not based on some mumbo-jumbo we overheard at a bar,read in a book, or created for ourselves by running a computer simulation.Successful trading is a function of several things all working at once, not aresult of opinion or conjecture—even if the source of that opinion or con-jecture has an impressive set of credentials. A tip is only one point of view.Right or wrong, the problem with the tip is not the data; it is the fact thatthe choice to assume the risk was not ours.

There is one other thing about tips that I think is critical to keep inmind. As you spend time in the trading arena and become more experi-enced, there will be times when a trade seems to jump off the screen at

Don’t Take Tips 131


you. It is abundantly clear which direction that market has potential in and,better yet, you can see it far enough in advance to really hammer the orderflow. You are going to make a lot of money on this one and you know it.

Then the phone rings and it is one of your trading associates. A con-versation starts about various opportunities you both have working andwhat you see coming down the pipeline. In a very excited voice you beginto extol the virtues of the trade you have just identified. With great confi-dence you tell your friend exactly what you see coming and why thattrade will be one of the home runs this year. After you finish your disserta-tion your friend is silent for a moment, and then you hear a voice withmore confidence than your own speak: “You are nuts! That market is dead.I saw a report on CNBC last month about that entire industry. You mightas well stand in the street tearing up $100 bills—you will have more fun.”You are stunned but still confident, and you restate your argument; afteranother 15-minute heated debate you both hang up.

Now you are in trouble, because the trade that appeared to be so cer-tain to you 20 minutes ago is in question. Your friend raised some goodpoints. He is not going to take the trade even though he asked what yousaw coming. Basically, because you offered someone a tip when asked,you opened your mind up to an argument about the quality of the tip. Youhad to defend and justify your trade conclusion to someone who has nointention of seeing it objectively. The emotional tug-of-war leaves you abit drained and wondering if, God forbid, six weeks from now that tradewon’t have worked as the way you expected. You will never hear the endof it. Of course, if you are a really weak trader you might decide to skipthat trade entirely after listening to your friend—which is also taking a tip.

The rule “Don’t take tips” includes the rule “Don’t give tips.” The mind-set of the tip giver and the tip taker are symbiotic and counterproductive tolasting success. If your goal is to remain a net winning trader, your dailytrade strategy must include some form of discipline where you neither givenor receive tips. If you are expecting your analysis to provide you trades to-day, you had better reevaluate your analysis. If you are looking for somethingin the daily news to give you the confidence to execute, you had better thinkthrough what you are expecting from the news. If someone asks you whatyou think of a certain market today, shake your head and say, “I have noidea.” Give yourself the best possible daily trade presence by reducing andeliminating any tendency to look for or take tips. By doing the same for tipgiving, you also improve your mental toughness. You stop the vicious cycleof opinion-versus-opinion conclusion making, which is not trading. Opinion-versus-opinion conclusion making is called the House and the Senate.

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133

RULE #22

WithdrawEquity

Regularly

Gold comes quickly to the one who does not hesi-

tate to save one coin in ten.

—First of the Five Laws of Gold from the bookThe Richest Man in Babylon

In the book The Richest Man in Babylon, by George S. Clason (NewYork: Dutton, 1989), the story is told of how a young man wishing tobecome rich learns the five laws of gold. All five laws are incredibly

wise and simple; I am amazed that people are still poor with this kind ofknowledge available. The first law is the cornerstone to wealth accumula-tion and this one law in and of itself will lead to wealth even if you don’tfollow the other laws.

In the story, the rich merchant teaching the young man tells howthe source or size of a man’s income is not important to building wealth;it is only important that a part of that income be regularly set aside andput to work. I can tell you from personal experience that my entire trad-ing changed for the better when I applied this rule to my trading ac-counts. There is something about obeying the tried-and-true laws ofwealth and money that make the issue of trading as the source ofwealth less important.

You might get rich from trading, but you don’t have to if you followcertain timeless principles while you earn profits of any size from yourtrading. It is a mistake to think that because the markets have unlim-ited profit potential you personally will accumulate unlimited profits.It is better to accept the possibility that you will earn a very nice in-come or a nice piece of the pie; but what you do with the accumulated


profits you have achieved is much more significant for your overallsuccess.

Rather than spend a lot of time on the basics of wealth accumulation, Iam going to assume that your intention with this book is to get a betteredge for your trading. Part of that edge is creating trading rules that willwork for you. If you look closely at the underlying psychology behind win-ning trading rules, there is a subtle, implied consciousness that they allseem to point to. That consciousness is nonattachment. All winningtraders have as part of their market presence or daily discipline an awak-ened knowledge that pretty much anything can happen at any moment. Ifthat results in an adverse move to their market position, they will ruth-lessly liquidate. If something unexpected happens that pushes a trade fur-ther in profits, they might aggressively add to the position. When a trade isnot performing as anticipated, they will liquidate or lighten up. Basically,most winning traders are not attached to any particular result, price area,profit/loss ratio, or even any one market. Winning traders know that any-thing can and does happen, and that if they have any kind of internal com-mitment to any part of the trading experience they have a higherprobability of losing money. That nonattachment extends to their accountbalance, and this is why regular withdrawals from your account are a veryhealthy thing for your trading.

This rule is about maintaining a strong market presence. A strongmarket presence should be thought of as a whole picture. There are a lotof things that can affect trading, and many of those things are not directlyrelated to the markets themselves. For example, if you have a conflictwith your spouse and your emotions are in turmoil, it is very likely thatyou would incur a loss if you initiated a new position. Something from theoutside world is pressing in on your inner world. Stop and think abouthow people you know have made poor choices when they have been sub-ject to something that upset them. Trading is no different. To maintain astrong market presence you must reduce or eliminate outside pressures,as they might disrupt your thinking or emotions. Included in that pictureis the issue of what to do with money earned from trading.

Obviously, you need to be a net winning trader to follow this rule. Ifyou aren’t a net winning trader at this point, it is still a good idea to con-sider removing money from your account from time to time. Money is a vi-tal and necessary part of our day-to-day lives, and as such, it should bemoved around occasionally as our world changes. The surest way to gobroke is to put your money in one place and leave it there forever. Moneyneeds to be used to be valuable. Opportunities change, people change,things that were great investments in the past are no longer good today;money works hardest for you when you are moving it around to take ad-vantage of the changes around you.

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If you take the point of view that most winning traders do, you will findyour trading improves when your trading plan includes withdrawing fundson a regular basis. You really don’t need a huge chunk of money in yourtrading account to exploit market inequalities. Most of us can focus ononly so many markets at one time anyway, so having gains pile up and justsit there is pointless. I know that many traders take the point of view thatmore cash in their account means they can trade larger. You might be sur-prised to learn that most long-term successful traders don’t load up. Mostsuccessful traders are very careful about increasing their base trading size.Instead, when their account balance reaches a certain number, they simplywithdraw their gains. Most do it as a measure of self-protection; theyworked very hard for those gains and don’t want to risk giving it back.

These traders also know, usually from past experience, that increas-ing their trade size has resulted in a larger ebb and flow to their balance.Many simply can’t emotionally negotiate that big of a changing balanceday-to-day. These traders are content to trade a certain size and do it verywell. Withdrawing money regularly prevents the temptation to changesomething that is obviously working for them.

Additionally, what are we doing this for, anyway? Isn’t the whole pointof trading to get rich? I know it is for me. I think whatever trading repre-sents for you personally, somewhere in that point of view is the issue ofwhat to do with the money. Many traders make the mistake of having noreal financial goal to work toward. Goal setting is an important method tomonitor actual progress on improving your personal financial position.Assuming you have some financial goals you are working toward, don’tmake the mistake of thinking you will attain them all at once when yourtrading balance reaches a certain point. It is wiser to break those goalsdown into mileposts and make a contribution toward them on a regularbasis as your trading account grows.

For example, I have a friend who withdraws a certain amount of hisgains every quarter and puts them in bank certificates of deposit. He doesn’tcare about the interest that is paid; he does this so that he can’t get hishands on the money easily or lose it quickly from overtrading (which hehas a tendency to do). He lives in a modest apartment and he is looking toput 50% down on a condominium. This particular trader has blown outmore than once, and his rules now include, “Once I have a certain gain, itgoes in the bank toward owning a home.” When this trader withdrawsmoney, he is validating his sense of purpose and progress. He feels goodabout working toward financial independence and security as he definesit. He is happier and more focused, which leads to a better market pres-ence. Better market presence, better trade results—they go hand in hand.

Withdrawing money and putting it somewhere is only part of thestory. I think you will maintain a much better market focus if you also take

Withdraw Equity Regularly 135


a portion of your gains and do something that is personally very reward-ing for you. When we as traders have invested a year of our lives andmaintained a sharp edge during that time, sacrificed things to make a niceprofit over time, we owe it to ourselves to reward ourselves in some waythat is deeply satisfying. There is a very powerful sense of satisfaction thatcomes when we stop to enjoy the fruits of our labors and invest in our per-sonal happiness. I don’t think it really matters what form this takes, justthat we do it for ourselves regularly.

I think this needs to be done no matter what level you are at in yourtrader development. If you are trading a $2,000 balance and earn a $500gain during the quarter, I think you should take $100 and buy yourself din-ner or something. I think it is crucial for us as traders to invest back intoourselves when we are achieving the success we have; God knows wehave earned it. Trading can be a brutal experience, and when we are onthe winning side, we should enjoy that success a bit. Of course, it shouldgo without saying that spending every dollar earned from the markets isnot a good idea. You need to find a balance between enjoying your successand saving.

In the final analysis, the rule “Withdraw equity regularly” is about theprocess of non-attachment to the markets. It is a daily battle for many ofus to hold rather loosely to our trades and their results. When you holdloosely to your account balance as well, I think you are completing the bigpicture of what the markets ultimately mean to you personally. How youchoose to define financial freedom is up to you. For me, just knowing thatI have complete control of my finances and I don’t answer to anyone is ahuge part of it. I really don’t care anymore about material things like Iused to. I take money from my accounts regularly and make secure invest-ments, I support a few charities, and I enjoy a lot of fun stuff. To me that isfreedom. I don’t think I could maintain that sense of freedom or daily bal-ance if I had a huge cash balance in my trading accounts going back to theday I started. What good does that do?

Your trading results when they are cash credits must mean somethingto you personally. Take that cash and use it; move it around and increaseyour opportunity base. Make a few long-term secure investments, buy avacation home, take your spouse to Europe for a month; do somethingpositive with those gains and you will be a sharper trader for it.

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137

RULE #23

Be aContrarian

Buy when there is blood in the streets . . .

—J. P. Morgan

Every trader has most likely had the experience of planning out atrade, waiting for the point he feels is the right price/time relation-ship, executing, and then seeing the market go the other way almost

instantly. In maybe only a few seconds the market has taken a large chunkof equity away. If this has happened to you, you know the feeling of confu-sion and sometimes anger that results—all that preparation and workgone out the window.

Many traders attempt to analyze the result and look for a way theycould have seen that situation coming ahead of time. Other traders try tofigure out how they could have seen the other side and put the oppositetrade out instead of their first choice. In my view, all of these responses tothe result are leading to worse trader performance. Analysis of the marketcan only go so far to begin with and the fact is, the loss most likely camebecause you were following the crowd. True, you may not have knownyou were following the crowd at the time but that is what contrary think-ing is all about.

Many fine books have been written on crowd behavior. I have in-cluded a few titles in the Recommended Reading section of this book. Idon’t think we need to go deeply into the psychology of crowds in thisshort rule, but I do think it is worth noting that all markets are crowds. Asa trader looking to build a strong market presence, you really don’t need


to become an expert on crowd behavior. You only need to know what thecrowd behavior is most likely to be at some point.

What motivates the crowd? I have spent a lot of time getting my think-ing around the concept of markets as a crowd, and I think I can say withsome certainty that a market is in reality nothing more than an expressionof three basic emotions: fear, greed, and hope. The other things thattraders feel compelled to focus on as a support system to create confi-dence all boil down to a reason to hope, a reason to get paid, and a reasonto pursue a profit with less fear. But the underlying emotional structure ofthe market is based on the need to avoid pain and the desire to makemoney. This is why traders are tempted to hope a market comes backwhen they are holding losses, why they hope a market continues furthertheir way, why they get out if the market starts taking away an open-tradeprofit, why they hesitate to do the right thing at the right time, and all theother various behaviors that increase probabilities of net losses. The bot-tom line to all of this is trader behavior, and that behavior is driven bythese three emotions.

Net winning traders still have these emotions, but they have one thingthe losing trader does not: a deeper understanding of the crowd they par-ticipate in. Net winning traders also know that their behavior must be dif-ferent from the crowd’s behavior. This difference in behavior is theessential part of contrary thinking.

Almost all winning traders have controls on their behavior. That iswhat this book is really all about: giving traders a clearer understanding ofwhere they need to focus their thinking and behavior. Creating your per-sonal daily trade rules comes from an adequate understanding of the psy-chology you need in order to achieve net winning performance. Netwinning traders experience all the same emotions as losing traders, buttheir behavior controls prevent those emotions from becoming losing be-

haviors. One of the absolute best controls you can develop is the propen-sity to stop thinking like the market crowd to begin with.

Most discussions of contrary thinking seem to focus more on learningto be bullish when the market is bearish, or vice versa. Actually, that is auseful tool, but I am not going to have that discussion. I am suggestingthat contrary thinking is more about understanding that the crowd isthinking along certain lines and you need to think along a different line.Sometimes that means you need to be looking at the bullish scenariowhen the market is declining; sometimes it means you need to fade thenews; sometimes you need to stay away for a time.

The crowd behavior will almost always be driven by fear, greed, andhope, and those emotions are stimulated in the crowd by price action orthe absence of price action. Remember, the prices mean something to

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each participant. When that meaning becomes an urge to action, a traderesults. For example, if a market is declining against someone’s open long,that means a trader is losing money. He wants to avoid that pain, so hewill either hope the market reverses or get out if he fears a further pricedecline. Once that urge gets strong enough, the trader will liquidate. Whatdoes that kind of behavior look like in the actual market price action?

In your day-to-day analysis of the market, you would do better if youlistened closely to the personal meanings you associate with price action.For example, most traders tend to use the word strong to attach meaningto a market rising in price. Weak describes a declining market. Now, if youlook closely at what you are doing when you attach meaning to a price di-rection, you have more clues as to how other traders, too, are most likelyobserving price action. In other words, the crowd believes the market isstrong when prices are rising. What do you do with a strong market? Youbuy it, of course; strong is good.

At some point in this strong market the available universe of potentialbuyers will have come to that same conclusion and have placed them-selves at risk. They will have bought a position, correct? Now the marketfails to advance. The buyer is afraid the strong market will now weakenand the potential exists for a loss. This fear now drives the buyer to sell,creating a self-fulfilling prophecy. If this whole dance happens withenough participants then the previously strong market now becomesweak and prices decline. The buyer has a loss—but the seller who let himin is the winner.

To be that winning seller is not as simple as being bearish when every-body is bullish; it’s more a process of knowing enough about average emo-tional thinking and how that will stimulate someone to do something. Inthe markets, you are looking for the point where that has already hap-pened. When the market has run out of buyers, it is physically impossiblefor that market to continue to advance—all the force that could be ex-erted on the buy side has already happened. All it takes is one seller tostart the ball rolling the other way.

But in either case, the market is neither strong nor weak; it is simply amachine, processing orders in one direction or the other. What you are at-tempting to do is take advantage of the changing net order flow. That netorder flow is created by the actions of each crowd participant. As eachcrowd participant comes to a conclusion and executes, the market is pre-set to go the other way sooner or later under some time frame; those initi-ating orders must eventually be offset with a liquidating order from theother side. Contrary thinking is about understanding that the crowd is do-ing one thing from the net perspective every day and that they will have todo the other thing eventually, maybe in a time frame you can see right

Be a Contrarian 139


now. In other words, once everybody has entered the market, they mustleave the market sooner or later. You as a successful trader are attemptingto be just ahead of that change in the net order flow; most likely that willmean a buy order when everyone is selling, or a sell order when everyoneis buying. Contrary thinking is about being in the right place at the righttime to exploit the crowd thinking.

It is important to remember that most people can come to a conclu-sion that is fairly accurate. Accurate thinking is not the same thing as ac-curate behavior. Many traders with only average understanding offundamental and technical considerations can call a market. I am surethat you personally have come to the conclusion that a market was bull-ish or bearish, and that conclusion proved over time to be the right one.Calling a market is not the hard part, in my opinion; the hard part is buy-ing or selling at the best times to capture the move. I am certain thatsome of my readers have been 100% correct on a market but didn’t makethe potential gain for their account, or even had losses. The issue there isnot the understanding of market potential; it is the lack of understandingregarding crowd behavior.

Most traders are not very skilled in reading the crowd well enough toknow when the market is due to move the other way against the mostlyright market call. In other words, wait for the correction or confirmationbefore entering the position; and that is often at the point when the earlytrader is liquidating with an early loss. Just knowing the underlying mar-ket potential is not enough to get in a winning position. You must alsothink differently about the same conclusion the average market partici-pant has come to. If everyone is bullish and the market is indeed rising,everyone is thinking the same thing: Get long, buy a pullback. But therewill be a certain percent of bullish traders who will be washed out on thatcorrection for various reasons and actually have a loss, even though theywere right about the market. You want to be a buyer from those traderswhen they sell off their poorly set longs.

Knowing that potential going in every day is how you exploit thecrowd’s behavior, and that is contrary thinking. Contrary thinking is notcoming to a conclusion that is different from other traders. It is not beingbullish when everyone is bearish. Contrary thinking is about understand-ing the game so well that you know when it is time to go against thecrowd. Your thinking process starts in a different place and you are notlooking to be a bull or a bear in any market. You are attempting to out-think a crowd that does very little thinking in the first place. Sometimesthat means you buy an upside breakout because you know the short hashis stops up there; sometimes you sell into a rally because you know thecrowd is buying the news; sometimes you stand aside because you knowthe bulls and bears are whipsawing themselves and you need to let the

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dust settle. Contrary thinking is more about thinking beyond emotionalbehavior, and then having the courage to exploit it without making thesame mistake the crowd is making. In other words, you execute againstthe crowd when the time is right, and then you don’t panic, scare yourselfout, cut a profit short, or hope the market comes back if you are losing.You control your actions fully by discipline, but those actions come from acompletely other kind of confidence.

Be a Contrarian 141


143

RULE #24

All MarketsAre Bearish

Pssssttt . . . want to know a secret? There is no

such thing as a bull market!

—Attributed to Jesse Livermore, 1921, a raging bear

Knowledge is power. In the trading environment there are differentkinds of knowledge, and some knowledge is more powerful thanothers. The most powerful kind of knowledge remains knowing

the net order flow; everything else is more along the lines of helpful information.

During the process of gaining the knowledge I needed in order toknow which knowledge is really useful, I had to make a lot of observa-tions. Those observations were of people, people’s behavior, trade fun-damentals, technical study, and general market conditions. Over theyears, I have seen a lot of strange things as a full-time trader. I supposethere are hundreds of stories I could tell you about blowouts, blunders,quick fortunes made or lost, unbelievable risks taken or ignored—allsorts of things. I have had my share of wild rides, and as any seasonedtrader can tell you, any trader’s results are 100% personal. We createthem and no one else is responsible for them. We hope for consistentpositive results, but until we discover our personal winning trademethod, we will have losses.

As we get more educated, as we get the knowledge we need, we dis-cover how many of our losses were avoidable. As the stories that areour personal trade results get created, and as we develop better skill,


we realize how many of our negative results are self-created. There arecountless different ways to lose money. Of course, the absolute worstkind of loss is the one where we simply did not do our homework. Forwhatever reason, we chose a trade, executed, and had a loss, but thatloss was completely avoidable. If we had just known what we needed toknow, we might have avoided that loss.

Part of getting that practical kind of knowledge is a very firm under-standing of basic market structure. Basic market structure is like a play-ing field. To use a sports illustration, a football field is where the game isplayed. The game is dynamic and subject to rules that both sides mustplay by, but the playing field itself provides the basic structure.

One of the most important pieces of information you can possess aspart of your trading knowledge is the fact that bull markets are aberra-tions. All markets are inherently bearish. If you want to reduce the num-ber of trade conclusions you come to that are losing conclusions, youneed to understand that coming to a bullish conclusion needs a lot of sup-port. A bullish conclusion has a certain degree of extra risk. You would dobetter over the life of your trading if you started each hypothesis from thepoint of view that the market in question will be under net selling pressurein most cases. A bullish market conclusion or trade hypothesis needs atremendous amount of verification and support because in most cases thebullish potential cannot overcome net selling pressure long enough for aconsistent bull market to develop. Just knowing that all markets are bear-ish will save you a lot of time and money, because there will never be asmany quality long trades as there are short trades. You will prevent a lot ofneedless losses in your account when you are suspicious of bullish con-clusions in the first place.

I need to make sure we are all on the same page as far as an under-standing of the maxim “All markets are bearish.” For the purpose oftrading, equities could be excluded from this assumption because equi-ties are not a zero-sum transaction for the most part. I think of equitiesas a game of musical chairs, whereas futures, options, and FOREX are atug of war. Equities can pass from one owner to another regardless ofwhether the share drops in value, pays a dividend, is repurchased bythe issuer, gets absorbed by another company, and so on. Equities willoften be bought and held for decades. There are a lot of reasons to ownequities besides the net change in the share price. A bull market instocks happens when more money is pumped into the market, not whenshorts offset.

The zero-sum transaction market is a completely different animal. Ex-actly 50% of all contracts traded will be offset at a loss; there is no otherway for the market to function. Whoever holds the losing contract has aloss—even in a bull market there will be shorts that cover at a loss and

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longs that cover at a loss. But there is one important distinction that zero-sum markets have that no other market has: A certain part of the executedtrades will never be offset.

For the most part, zero-sum markets are comprised of two separateand distinct participants who have two very different, competing desires.They use the market for vastly different reasons. These two participantsare the speculator and the hedger. For the sake of illustration, let’s use asimple consumable commodity to document the net bearish nature of thezero-sum market. Every year, a new crop of corn is planted and harvested.Corn is consumed every day and eventually, if no new corn was plantedand harvested, we would run out of corn. For the sake of this illustration Iwant you to set aside all the unique particulars you know about the Cornmarket. Forget all about the fundamentals, technicals, oscillators or indi-cators, historical prices of Corn—everything. The only thing I want you tofocus on is the closed universe of actual executed trades and what thatmeans from a net perspective.

The hedger is the individual who grows Corn and sells it, probably afarmer. The purpose of the Corn futures market—the only reason it ex-ists—is for this farmer to exploit a high price at which he can sell his corn,often before he even grows it. As a farmer, if I am uncertain that the cur-rent high price will still be around when it comes time to harvest and sellthe crop I plan to grow, I would sell my entire projected crop at the cur-rent price of corn futures. If the price of corn goes higher, I can’t partici-pate in that additional profit, because I locked up my crop before then, butmy benefit is certain: I will have a profit this year. If the opposite happens,such as a big drop in corn prices, I will still have a nice profit this year be-cause I own the right to sell my crop to someone at a higher price—andthat contract is guaranteed by the exchange. The buyer of my crop is ob-ligated to pay that price.

The speculator, on the other hand, is looking to exploit price action tomake a personal profit due to changes in the price of corn. He probablyhas never seen an ear of corn except at a barbeque. He has no idea how itis grown or what it is used for besides eating at a barbeque; he spends lit-tle time speaking with farmers who produce the corn. He simply compilesthe data he finds valuable and decides when it is time for the price to riseor fall. He places himself at risk, and once that happens he will either havea profit or a loss; that is all the speculator cares about. As far as the specu-lator is concerned, the corn market is nothing more than a potential checkin the mailbox.

You are probably saying, “Yeah, I know that—I have been trading foryears. What does this have to do with a bear market?”

The point is—in this case—the hedger’s selling pressure is never an-swered with a corresponding buy order. The market has more net sell

All Markets Are Bearish 145


orders as long as the hedger participates. The hedger sells the market. Hedoesn’t have to buy the market. He may deliver against his position.Therefore the speculator who buys and sells is the net force on the mar-ket. Sooner or later that will create a permanent net selling market. To seehow, look at Figure 24.1.

Now, suppose the market has apparently become bullish. Speculators

are buying the market, and the sellers that are letting them in are otherspeculators. The losing speculators on the sell side continue to buy backtheir losing shorts, creating a price advance due to the net order flow im-balance from the buy side. Prices advance to a point that is considered toohigh for everybody.

Enter the hedger. The hedger sells, the speculative seller opens a newshort, and the open trade longs decide to liquidate and they also sell. Atthis point, that market is under three times the selling pressure it normallyhad been under up to that point. This is why markets always break fasterthan they rally. Once the winning shorts from above the market decide tocover, that is the only buying pressure left. When those winning shortscover, the game is over. The losing longs have to sell at a loss and thehedger doesn’t have to let them out. The hedgers from above the marketdon’t have to do anything. In fact, a bona fide hedger is not subject to mar-gin requirements or forced liquidation to begin with; once they sell intothe market, they really are under no further obligation the way the specu-lator is. The bull market was a temporary aberration that was exploited bythe hedger or professional short-seller. The longs had no chance net, even

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FIGURE 24.1 Forced Liquidation Matrix


though the price advance may have been several months long and manyshrewd traders may have pulled some money out.

Obviously, the relationship between the hedger and the speculator ismore complex. Hedgers will scale positions into a price rise; they will buyback on breaks in price to confuse participants as well as draw morelongs in. Speculators will be long from one area and then short at anotherarea; fundamentals will develop that change the way participants are see-ing new price potential. All sorts of things will play out during a temporarybull market. The essential thing to remember is that sooner or later thehedger will have exploited the market from the net sell side and will sim-ply wait for the speculators to exhaust their potential. Once that happens,the remaining net short potential will crush the remaining longs untilprices return to a lower equilibrium.

If you want to see historically how bull markets are exploited by pro-fessional selling, try looking up the data for the grain bull market in 1988.If you look at the highest prices paid when the rally had become exhaus-tive, compare that to the Commodity Futures Trading Commission(CFTC) “Commitment of Traders” report. Note the net short position heldby hedgers for the two or three weeks leading up to the highs in thegrains. The record high open long positions by speculators were all placedinto the market during that time as well. There was nowhere for the priceto go but lower as those losing longs liquidated and added to the sellingmomentum. By September of that year prices had fallen back to within ashort distance of the ones traded in the spring. The hedgers simply sat ontheir hands for the most part as prices hit the highs and then declined. Bythe end of the year, the open trade gains and losses had all been liqui-dated; delivery notices were not any bigger than usual. Most of thehedgers had covered their shorts, too, probably because the distance ingain was enormous and there was no need to actually deliver the grainagainst the short contract. The grains have never traded to those highsagain since that time, as of this writing in 2006. In fact, due to grain in stor-age and the import/export situation at the time, there was no real shortageof grain at all, even though some of the crop was lost to the drought thatyear. There was no bull market. There was a selling opportunity.

I am not trying to oversimplify. I realize that fundamental changes areoccurring in the breadth and scope of the marketplace. I know that priceaction is not as simple as described here, but the important thing is to un-derstand is simply this: Markets exist for the hedger’s benefit. In mostcases, the higher the price goes in any market, the more the hedgers willexploit that from the sell side. Very few markets are used by hedgers fromthe buy side, and when they do use them, they don’t want higher prices ei-ther. In both cases, the hedgers really want the buyer to come to the tableand play—to assume the risk they don’t want. A selling hedger needs the

All Markets Are Bearish 147


bull market to sell into; he only needs one bull market every few years tohedge several years out. The buying hedger will liquidate his buy hedge atthe drop of a hat because it is in his best interests for the price to decline.

Think of it this way: No matter what happens to the fundamental pic-ture, once a bull market develops, the selling hedger will cap that marketsooner or later and the buying hedger will sell off his longs once the bullmarket is over. Both kinds of hedgers need the blood of the speculativebull to return prices to equilibrium after they have protected themselves.By the time the dust settles, in almost all cases, the number of sell ordersthat have been executed is greater than the number of buy orders; the re-maining numbers of open shorts are delivered against. This doesn’t haveto be a large number of open contracts, only enough to tip the balance tocreate a no-win situation for the speculative bull who must add pressurefrom the sell side to take his loss. All three eventual sellers execute, andonce prices are lower, the sellers who choose to cover by executing fromthe buy side will always be fewer than the open shorts who will holdthrough delivery.

If you are going to trade under bullish conditions, learn to be hyper-vigilant on the activities of hedgers and professional large sellers. Theyare going to use that bull market to sell into, and when the stage is set,that market is going south in a hurry. Always remember that bull marketsare temporary.

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149

RULE #25

Buy/Sell 50%Retracements

You can make a fortune following this one rule

alone.

—W.D. Gann, The Tunnel Through the Air

Most successful traders will tell you that their systemized ap-proach to executing trades is “very simple” for them. Theymight appear to be analyzing the market differently than losing

traders do, but in reality they are not doing anything different—they arejust simplifying the bedrock issue of identifying the net order flow.What they have learned from experience is that certain types of marketbehavior look like the same thing to them every time. From their per-sonal trade results, they know that what looks like the same thing hap-pening is usually followed by a certain higher percentage of priceaction in a certain direction. In other words, once something happens,and it looks like it is time to buy, since their historical results indicatethat they are correct about 67% of the time, they buy. Obviously, the keyis in how they are defining what the market “looks like” to them. Mostwinning traders have a systemized approach that includes a certainamount of basic analysis and discipline, but this “looks like” thing is anintuitive issue.

Developing a winning approach takes time and discipline. You needto keep it simple whenever possible, and you will always do betterwhen you boil down whatever you are learning to the essential teach-ings contained inside the theory. That is what this rule is about, creatinga very simple tool to use successfully. One of the best ways to develop a


winning approach, to add that “looks like” component to your personalresults, is to enter positions on 50% retracements.

I want to make one thing abundantly clear: 50% retracements arenot Fibonacci study, projections, or retracements. Fibonacci was a Re-naissance mathematician. He was interested in uncovering the grandharmony and design of the universe. He wanted to find the all-pervad-ing, bedrock component to the nature of physical reality—what you andI would call the essence of the physical universe. He lived in a timewhen money was a very unsophisticated concept. The general level ofignorance in which people existed at the time just before he lived wasprofound. Fibonacci’s discoveries would have been seen as dramaticleaps forward, so much so that they looked like magic and bordered onheresy.

Still, Fibonacci believed things about the nature of reality that youand I know today are completely erroneous. For example, Fibonacci wasan alchemist. He believed with all his heart that he would discover,through mathematical design and prayer, the very nature of reality. Whenhe did, he would exploit this knowledge to turn lead into gold, therebyending his money problems. If I told you that as a trained trader I willtrade for you, and that I will execute for your account by studying theflights of bees, you would be no worse off than if you followed Fibonaccithrough his day as he tried to turn lead into gold.

Fibonacci never applied the golden ratio or the Fibonacci Progres-sion to markets or trading. None of that existed yet. Fibonacci discov-ered a part of nature that is accurate for the study of nature, nothing else.He didn’t know that at the time. He himself lived under a cultural illusionand wasted his knowledge pursuing something that couldn’t physicallybe done.

Why am I telling you this? Because Fibonacci retracement study is anaccepted method of simple technical analysis. All successful traders usesome form of retracement analysis in their simple methodology. But Fi-bonacci never intended his discoveries to be developed or applied to trading.That was W. D. Gann’s idea, so your best bet in understanding retracementsis to study W. D. Gann, not Fibonacci.

Gann discovered a unique relationship between time and price that isstill considered accurate today. That relationship is apparent across allmarkets in all time frames; no successful trader should ignore it. The rela-tionship is very simple and actually was initially discovered by Fibonacci,except Fibonacci had no use for this knowledge—he was busy goingbroke trying to turn lead into gold.

The time/price relationship follows the rule of 72 and 50% ratios.Some of this is also covered in Elliot Wave analysis but I want to make thissimple. Any time pundits of Elliot Wave, W. D. Gann, or Fibonacci start

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talking they complicate this whole retracement issue so dramatically thatyou would think the sun rotated around the earth just prior to the mooneating it. People need to just relax and focus on the main issues.

Fifty percent retracements are important because they balance thenet inequality between the competing net order flows. That’s it. Retrace-ments do not predict price action or portend new highs or lows. Retrace-ments are not predictive. They are historical. The reason Gann, Elliot, andFibonacci are all included in this discussion is because they happened tonotice the relationships first—though they didn’t necessarily understandwhat it might be saying. Fibonacci noticed that a mathematical ratio ex-isted in nature. He assumed that lead and gold would also be subject tothis natural ratio but, as we know now, this is not true. This ratio is appar-ent in nature and in the way things grow; it is not apparent in crowd be-haviors, and markets are about crowd behaviors.

Gann asked the question, “What if the market has a ratio and rhythmin and of itself?” Gann thought he had found an answer to that questionwhen he and Elliot noticed that markets appear to have waves that occurwith regular frequency and repetition. By combining these two assump-tions into a larger assumption, we now have a supposedly “verified” math-ematical model to follow in pursuing our trading success.

But the apparent relationship is not the same thing as the real rela-tionship. The real relationship is what we want to discuss.

Fifty percent retracements happen because once enough buyerssquare off against enough sellers, only half of those contracts will be prof-itable. At the 50% number, exactly half the bulls have a profit and half thebears have a profit. When I say this, it is important to note that this is a net

perspective. The actual result to any one trading account isn’t the issue. Ifyou could find a way to look into the total number of open trades, youwould see that of the sum total of the open longs, about half of that totalnumber of open contracts will have an open-trade profit—the others willhave losses. In other words, if there were 10,000 open longs, around 5,000of them will have some open-trade gain and the other 5,000 will have someopen-trade loss. The exact same situation will be accurate for the shorts.The market is now temporarily balanced from the net perspective.

This situation won’t last long; it will only take a short time for newbuying or selling pressure to come in. Whoever has the net advantage atthat point will tip the balance. Most of the time it is in the original direc-tion back toward the previous high or low because from the net perspec-tive the late loser entered from the short-term trend—that is, the few daysor so just before the 50% level is reached.

This is a factor of the rule of 72. Most market participants operate on atime frame of 72 hours or less. That means that in all the various ways ofcreating a market timing signal that now is the time to initiate a position,

Buy/Sell 50% Retracements 151


most traders have gotten at least one signal in a 72-hour period and haveexecuted, creating net order-flow. Once they have initiated, they must liqui-date to accept their open-trade profit or loss. Most methodologies will havegiven the exit signal within that time frame as well, with the net result thatalmost everybody has gotten in and out at least once within a 72-hour pe-riod. If this process happens at a 50% balance point, the net result is usuallya resumption of he previous trend. See Figure 25.1.

HOW TO USE THE RULE

First you must select a significant high or low price previous to the pricethe market is currently retreating from. When I say significant price Imean a price that is around 72 bars back in time; also they are usuallyweekly, monthly, or daily price points. If we use a bullish scenario, you arelooking for a previous important low price and the market is retreatingfrom the most recent high. If you use a daily chart, as used in Figure 25.1,your previous low price must be about 72 days/bars back or so, I find thaton longer time frames anything substantially less is not as accurate, andanything significantly more is usually ignored by traders as “old data.”

Place a 50% retracement study between the old low and the new

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FIGURE 25.1 Buying and Selling 50% Retracements—Cash Euro/USD. FOREX,April 2005 to April 2006.


high—that would be your best buy point. That point will be some time inthe future that approximately reflects the 72-bar ratio. This is why a pricecould trade to a high and Gann would say, “By this time next week, themarket will trade at _____ (price).” He would be merely projecting his ra-tios and computations forward some amount of that ratio as a price/timerelationship. Of course, the opposite would be a sell point if you weretracking a rally in a bear market. But the underlying psychology behindthe 50% retracement is not about resumption of a previous trend or afailed reversal; it is about the late trader who entered in the last 72 hours.

Most people who initiate a position—about 80% of the total warmbodies sitting in front of a trading screen—are going to do at least one fullround turn in the market just prior to the market reaching the 50% pricearea. The vast majority of those traders are looking to make money right

now. If they follow standard technical analysis or use any of the mostcommon methodologies, because the market was trending lower for morethan 30 bars from the rejected high to the 50% point, they are looking tosell into the market and join the apparent downtrend currently inprogress, from their point of view. Their focus is to get positioned on theshort side because “the trend is your friend.”

But the market has just become balanced momentarily. That meansonly one thing. The shorts from above the market will cover; they have themost recent 72-hour open-trade profit. The late shorts cover, adding to thebuy order imbalance as they take their loss. Last, the old longs on thegreater-than-72-bar time frame (the 20% of long-term traders, the oneswho know how to follow this rule—the professionals who know you need

more than 72 hours to beat the loser) add to net winning open positions,many of which they have owned since the turn under the market. Theyknow that the retracement is coming and it will draw in late blood. Sothey gladly sit through the 50% retracement with at least part of their orig-inal position. Of course, the exact opposite scenario develops when a de-clining market rallies 50%.

Now obviously, markets don’t always turn on a dime once they re-trace 50%. Sometimes they take more time to balance temporarily; some-times they need several more or fewer bars than 72; sometimes they sit atthe 50% level for a bit and then retrace farther before moving back in theoriginal trend. None of that is the point. The point is, if you want to make alot of winning trades and keep it simple, enter your position at the 50 per-cent retracement point and wait. More often than not you will get at leastsomething you can work with.

When you combine this rule with Rules #11, #14, #16, and #17, youhave a huge potential to take a lot of money when a market still has moreto go and you are willing to wait for it. In fact, you only need a handful oftrades a year if you are willing to think ahead more than 72 bars when you

Buy/Sell 50% Retracements 153


are developing a trade hypothesis. Traders who have hit the home run,traders who have been long a bull market when an honest-to-goodnessshortage is developing or short an hysterical bull market when thehedgers finally cap the rally, will tell you that when the 50% retracementhappened, it was truly a thing of beauty and the money rolled in.

One last thing before we close out this rule: In fairness to all the peo-ple out there who are legitimate experts on the theories of Gann, Elliot,and Fibonacci (which I am not), I really don’t intend to discredit anyoneor their theories. I just think that the essential part of what these men canteach us is best found when we use some simple common sense. No onehas a secret method, and there is no perfect technical approach. Thesegreat men of history and of the markets found pieces of the deeper truthand expressed it the best they could. Only they could know how to use thesum total of their knowledge in today’s markets; the rest is conjecture andopinion by people who never knew them personally.

I think it is important to remember that the essential part of marketknowledge is simplicity. Remember, Livermore was a contemporary ofGann and Elliot and made more winnings then they did combined. Liver-more never used these kinds of analysis. He understood people and howthey behave, so well that he could read a market better than others couldanalyze a market. I think the best traders are those who read the marketsfirst; I don’t think the analysts are thinking along the same lines. StudyingGann, Elliot, or Fibonacci by reading their books is similar to saying youunderstand Beethoven well because you can read his music scores.

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155

RULE #26

The OnlyIndicatorYou Need

You should try to buy weakness and sell strength.

That’s the crowd panicking. The problem is, how

do you know they are getting in or getting out?

—Mark Twain, Discussions with Nikola Tesla

Many people are unaware that Samuel Clemens (Mark Twain) was atrader. During his time, traders were referred to as “Speculators”and they had a somewhat unsavory reputation. Speculators were

seen as exploiters, making money from other people’s suffering or need.The worst form of speculator was the carpetbagger who helped rebuildthe South with Northern money after the U.S. Civil War. Clemens himselftraded in cotton and grains but with little success, according to some bi-ographies of his life.

At the time, the development of futures contracts was in its infancy.The Chicago Board of Trade was only founded in 1848 and probablywouldn’t have survived if futures contracts hadn’t caught the eye of the vi-sionary industrialists and large farmers. Most of the attention that was fo-cused on market opportunities revolved around the Industrial Revolutionsomehow. Speculators were often involved in buying land that they hopedto sell to the railroads or lease for the right of way, buying steel to sell toship builders, and so on. Only occasionally did speculators trade in fu-tures for consumable commodities; it was still a new concept. But eventhen, during the late 19th century, people saw ahead to the explosivepotential in financial markets, and a new class of finance evolved. In to-day’s world, financial brokers are the gateway between market opportuni-


ties and capital—even now when electronic trading typically bypasses thetraditional brokerage relationship.

One thing that remains constant in the process of financial evolu-tion is the concept of inside information. To this day, part of what peo-ple view as a trading edge is knowing something ahead of time that ispotentially market moving. This is not quite the same thing as a tip. Get-ting a tip means being advised what to do by someone who allegedlyknows something. Market information or trading edge is more aboutfinding a better way to do something that is already known to work. Inthe opening quote for this rule, it is apparent that Clemens understoodthe basic nature of the market and knew it could be exploited; his prob-lem was getting the information required to know whether he was inthe right place at the right time. This is where the whole business ofanalysis and indicators came from—an attempt to quantify market in-formation to exploit what already works. The basics of trading havenever really changed.

Remember, some of the biggest fortunes ever made from tradingcame at a time when the only tools available to traders were their guts, in-tuition, and knowledge of the crowd. I say this because, as you will haveguessed by now, I put only a small part of my trade study into technicalanalysis. I know many will stop there and form some sort of value judg-ment. They might assume that because I don’t use what they have used,and they are making money with it, I must not know what they know; per-haps I don’t know the experts they know, or maybe I just have an axe togrind. They might say I am not qualified to discuss technical analysis be-cause I don’t use technical analysis the way they do. The proof is in thepudding, they would argue.

I say this about big-money traders and historical finance because suc-cess without analysis is factual history—not because I feel that analysishas no place in trading. Quite the opposite. Successful technical analysiscan be a very important part of lasting trading success but, as discussedin Rule #15, like it or not, it can only go so far. The fact is that using tech-nical analysis is like an unskilled carpenter using power tools. Withoutthe basic knowledge of carpentry, an unskilled carpenter will make awreck of house building when he is turned loose with better tools than heknows how to use. That brings us to this maxim of “the only indicatoryou need.”

But first we should clarify the thinking behind most of the indicatorscurrently used. Most indicators and oscillators attempt to quantify theconcept of overbought or oversold. The psychology behind this thinking isactually very sound, in my opinion. The idea that the market can getoverextended in one direction or the other is not a new idea. It is one ofthe cornerstones of successful trading. That is one of the concepts that

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will work for successful traders. The problem is not that the market canand will get overextended; the difficulty is in calculating when that pointis reached. Oscillators and indicators are notorious for being lagging indi-cators for the simple fact that they are historical and not predictive. Inmost cases, due to the historical nature of these calculated mathematicalconcepts, they have often identified a reasonable overbought or oversoldarea but by the time the signal is verified, the 72-hour/bar rule (from Rule#25) has come into play. The market you suspected was overextended hasalready begun correcting the other way, and usually that distance hasbeen a substantial move already. Also, most oscillators and indicators aretrend following; they help you get positioned in a trend but will never getyou positioned at the turn. In addition, by the time the signal to enter thetrend is verified and you execute, the very next correction will likely beright back to your entry price or a bit lower. No real progress in any case.

The newest class of oscillators and indicators attempt to be predic-

tive in nature. Many of them are based on extremely complex computa-tions that can only be done in real time by computers. We call traders whouse them the “black box” traders. Again, there is nothing wrong with thiskind of approach except that it simply cannot account for the most criticalpart of trading: What is the crowd thinking?

It is crucial to remember when you are using oscillators or indicatorsof any kind that they are only mathematical computations. They are allmoving averages in various degrees of complexity and performance. Theyare based on assumptions about the nature of markets and they work un-der the theory of probabilities. Behind all of these attempts to find a betterway to do what is already known to work is the issue of historical versuspredictive. If you are willing to accept that indicators, oscillators, andtechnical analysis are historical and not predictive, you are left with theonly indicator you really need: Who is getting in and who is getting out?

That brings us to the study of volume and open interest. In my view,this is the only indicator you really need because this is the only indicatorthat discloses fairly accurately what the crowd is thinking. Either peopleare getting into the market or they are leaving the market. Since we al-ready know that most active traders are losing every day, then we knowthat a change in open interest means people don’t want to play, are con-vinced they will win, or can’t take the pain any more. If open interest riseswe can fairly safely assume that traders are confident to get into the mar-ket from both sides. If open interest is dropping we can safely assume thelosers can’t take the heat anymore. If all of this is accompanied by higheror lower volume, then we can fairly safely judge the level of fear, panic, orhope that traders are expressing.

Now, to be fair with everyone, correctly reading volume and open in-terest is not as simple as I make it sound. But the underlying psychology

The Only Indicator You Need 157


will always be the same. By understanding the relationship between priceaction, volume, and open interest, you can get a fairly accurate read onwhat the crowd is thinking. Of course, this is an art form and not science.Markets can change in character in a heartbeat and your understanding ofV/OI may have been completely accurate 20 minutes ago but at this pre-cise moment something has changed. That is the dynamic part of tradingand part of what makes V/OI so useful. V/OI is the first indicator devel-oped, and everything after is an attempt to improve upon what V/OI cando with one important difference: V/OI has no time/price relationship.

V/OI is historical from the point of view that it discloses how big themarket is or whether that has changed somewhat. V/OI also discloses howthick the market is and whether that, too, is changing. When you combinethis information with a price advance or decline, you can discern whethermore shorts or longs are opening positions or covering, whether they areexecuting more often or not, whether they are losing confidence in theirpositions, and a host of other types of information that make it possible toanticipate (not predict!) what is most likely to happen next. Once themarket closes for the day and this data is compiled and released by the ex-changes, you have a fairly accurate picture of the mind of the marketwhen you compare what you see to the price action and other indicators.

But because V/OI has no time/price component, you may see clearlythat the market is setting up for a price advance or decline but there is noway to know how soon or how fast that change in price will occur. Al-though V/OI is the single most important indicator because it discloses themost likely thought process behind how prices got to be where they are, itstill cannot predict or expose whether that thought process is ripe forchange or whether the change is imminent. That is the whole purpose ofall the so-called improved indicators and oscillators: to find the time/pricerelationship for that imminent change. The V/OI indicator shows you it isthere; the others try to say the time is now.

If you personally had to choose between the two indications, “Some-thing in the market has changed” and “Whatever is coming, it will come at11:00 A.M. tomorrow,” which would you rather have? In the case of themarkets, knowing that something has changed is the better choice be-cause only one option is available: a reversal in price. Does it really matterif that reversal happens in the coming 20 minutes or if it will take 20 days,as long as you know that the change will most likely be in only the otherdirection?

As I have said many times before, I am not trying to oversimplify theissue of timing your trades. My intention is to help you understand thatthe first and best indicator will always be volume and open interest be-cause it provides a more critical component: the issue of a change to the

structure of the market. In most cases, a change to the structure of the

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market means a price reversal of some kind because the traders who putthe price where it is are no longer in the market. The thinking of thecrowd has changed. Just knowing that piece of information can give yourtrading a distinct advantage. You just don’t know precisely when thechange will result in a price reversal.

Before we close out this rule I want to sum up a few things. First, thestudy of V/OI is not a small one. You need to make a consistent effort to un-derstand how V/OI can and does change. It would be impossible in thisbook to have a discussion about all the different ways you can begin to in-terpret V/OI in the space we have. I have included titles in the Recom-mended Reading section that will help you better understand this importantmarket study. Second, you must remember that all the other indicators andoscillators developed in the past 150 years are attempts to better quantifythe price/time relationship with V/OI as the foundation to start from. V/OIquantifies the depth and nature of the game as it has been played to date;V/OI tells you a change has happened or is happening. What you do withthat data is a reflection of your skill at anticipating what is likely to happennext based on your understanding of the crowd’s needs.

Last, V/OI is never predictive. No indicator or oscillator can be predic-tive. No form of analysis can predict future price action with any degree ofconsistency. The important issue is to have the tools you need, and toknow how to use them to improve upon what already works.

Samuel Clemens and the traders of his era didn’t have V/OI or any otherindicator. If he did, he would have known exactly how to use it and what itmeans because he understood the basics to begin with. Focus your energyon learning the basics, then understanding V/OI. At that point the rest of yourtrading stands a good chance of falling into place as a winning approach.

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161

RULE #27

StudyWinningTraders

We should accustom the mind to keep the best com-

pany by introducing it only to the best books.

—Sydney Smith, Forbes Thoughts

on Opportunity

Most people would agree that learning to do anything well involvesmany things working together in harmony. Various parts of the ed-ucational process carry different weight with each individual, and

in today’s world we suffer from information overload. Education as aprocess needs to be prioritized for each person differently because eachindividual may begin from a unique starting point. Reducing informationoverload is a critical part of the process, I feel, because with the Internetnow in full swing, we can literally see everything ever discussed on anytopic, if we have the time or the interest. Trading is no different. There is avoluminous amount of data available at the click of a mouse, most ofwhich won’t help you succeed, in my view. You need to know how to pri-oritize what you evaluate.

Narrowing your focus to get the best trade education can be done alot better by taking a step back and asking yourself a few questions. Thebest one is: Who specifically should I listen to? The answer is that there re-ally are only two people you absolutely need to be listening to. The first isyou. In Rule #10 we discussed record keeping as part of the process of ed-ucating ourselves to become better traders. By documenting our behaviorwe gain insight into our thinking. We can get the same benefit from otherpeople’s documentation if we choose. In addition to Rule #28, “Be a student


of yourself,” I think it is equally important to learn what has worked forother successful traders. No one in this business has a mortgage on thetruth, and anyone who is a consistent net winning trader has somethingvaluable to say. That information is contained in the books they write orthe books that have been written about them. So the only person besidesyourself you should listen to is every other successful trader. Betweenthese two people you will eventually get 100% of what you need to de-velop and maintain a winning approach.

Now, when I say “Listen to other successful traders,” I don’t mean“Listen to people who have a product to sell.” That may not be a goodthing for the limited resources most people have when they begin trad-ing. One of the more confusing parts of developing a winning trade ap-proach is that there is a lot of market-related information out there tolook at. Between the books, magazines, trading systems, audio series,seminars, free data, and so on, you could spend all kinds of money andwaste all kinds of time and never get any farther along than you arenow. In fact, I am part of that process. I personally offer a live six-weekseminar designed to improve your market presence, and one of the objections I always get from potential attendees is, “How is this coursegoing to help me trade?” Rather than take time here for those kinds of arguments or issues, let me just say that you have to weed through a lot of poor-quality information to get to the things that will help you. Personally, I don’t teach people to trade. I teach them to think forthemselves.

The point is that you as a trader can shorten your learning curve byeducation, but you need to be careful how you approach the educationalprocess. You run the risk of investing a large amount of your personal re-sources into places that will not help you advance your trading career. Inorder to prevent that from happening, I want to offer you a few sugges-tions about how to narrow your focus and get truly high-quality marketeducation for the money you have to invest in that direction.

Be sensitive and focus on the difference between trading systems

and trading. Trading systems are methodologies for improving trade se-

lection—in other words, ways to find a better place to go long or short.These trading systems are based on probabilities and past market perfor-mance, and they are often designed by people with little trading experi-ence. Often trading systems are computer software programs you can buyor try for free, books that describe the method and illustrate it with pastmarkets, or even multiple-day seminars taught by the developer of the sys-tem directly. This is learning a trading system, not trading.

Trading is the far more critical element and needs to be the centralissue in your education. Many very good trading systems are worthlessto most users of that system because the real issues of trading are never

162 TRADER MAXIMS


addressed. Learning to trade involves learning how to avoid commonmistakes, control your behavior, avoid emotional interference, and ef-fectively manage risk. A great trading system will not work if the userkeeps second-guessing the trade signals, doubling up on trades that arelosing, scaring himself out of a winner too soon, or making a host ofother missteps. Simply stated, a winning trading system is completelynegated by poor trading.

All successful traders learned how to avoid bad behavior while devel-oping or using a system. The surprising thing they all will tell the develop-ing trader is that the trading system is the smallest part of their approach.Every winning trader uses a slightly different approach, and they coverthe gamut of potential behaviors. Some winning traders are day traders,some scalpers, some position or swing traders, some spread traders; thelist is endless. Trading systems can vary, but trading cannot.

In my opinion, the best use of your educational capital is to divideyour education into both parts but spend more time on learning trading.Personally, I invest a few hundred dollars each year on books, tapes, andseminars. Since I don’t need to learn a system methodology anymore, Ibuy resources that are biographical in nature. I study winning traders, nottrading systems. Every year I go hear winning traders speak, read booksthey have written, or listen to audios they have recorded. By far the great-est return on investment has been focusing on how winners think ratherthan how winners trade. Because trading is a subjective and personal ex-perience, it is unreasonable to think that some other trader’s approachwill be compatible with my own or with my trading nature. It is far moreplausible to expect that winning behaviors are learned from experience,and that by seeing someone else’s experience as similar to my own, Icould learn how to improve my own behavior or avoid developing bad be-havior. Most winning traders will tell you they had a combination-type ex-perience of their own. They had to find or develop a trading systemcompatible with their personality or nature, but the biggest thing for themwas learning to effectively trade.

The best way to communicate this difference and why it is so im-portant is to draw an illustration from something that really counts.Imagine you are a soldier sent to the front of the action. Regardless ofwhat you would like to believe about the nature of this particular mili-tary conflict, the fact is someone on the other side of the battlefield istrying to kill you. It is not a video game or a training exercise. This timeyou are under real threat for your life. You don’t have a choice at thispoint, and certainly you are not the person to negotiate a peaceful reso-lution to the conflict; at this particular moment it is a question of kill orbe killed. Your enemy is faced with the exact same situation, and youcan rest assured that he is thinking the same thing about you. You don’t

Study Winning Traders 163


want to die and neither does he. By the end of the day this situation willchange and one of you will be dead.

Up walks the commanding officer and he gives you an order. He or-ders you and your squad of soldiers out into the heart of the conflict to es-tablish a forward position for the coming offensive. You turn around andsee that your commanding officer is a 23-year-old first lieutenant, justgraduated from West Point Military Academy. He is assuming his firstcommand after graduation and his orders are, “Go establish a forward po-sition.” You are being ordered into combat by someone with little or nocombat experience, and if he makes a mistake you run the risk of goinghome in a body bag right then and there.

Obviously, a trained soldier would execute that order, and I am notsuggesting that new military officers are not qualified. I am illustrating thepoint that, like it or not, book knowledge is different from combat experi-ence. Our hypothetical soldier would feel a lot less conflict about estab-lishing a forward position if the commanding officer was a three-stargeneral who has fought for his life many times and has personally beatenthis particular enemy army twice before. That general will most likely notorder a soldier into a losing position. At one point, that three-star generalwas a first lieutenant newly graduated from West Point as well, along witha group of other potential combat officers that year. They are all dead andhe is not. He learned how to apply the book knowledge better under com-bat and that is why he is a three-star general. Most likely he will see thetraps and pitfalls the enemy might try to set, and because he has beatenthis enemy more than once he knows how to exploit the weakness the en-emy can’t see.

Trading is a lot like that. It really is a kill-or-be-killed environment. Allthe book knowledge you have will not help when you are on the wrongside of the net order flow; you are losing the war at that point. Only com-bat experience will help you. Net winning traders have developed winningbehaviors from being in the heat of the battle and not getting themselveskilled. You as a developing trader will learn more from studying winningtraders than you will from studying theory, just like winning military offi-cers learn more from combat than they do from books.

The list of Recommended Reading at the end of this book includes ti-tles I found very helpful for the study of winning traders. All of the booksare readily available, and if you read them all you will most likely learnmore. I would encourage you to continue making the study of winningtraders a regular part of your trading approach. I am not suggesting thatyou ignore new developments in the art and science of market analysis. Inmy view, I think you will come to the same conclusion that I have. Afterenough time most of the market study you explore is all saying prettymuch the same thing. By balancing your education between trading sys-

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tems and trading, you will shorten your learning curve, without goingaround in circles while you trade your way to zero equity.

To make this rule work for you, your best bet is to discipline yourselfto spend enough time daily to read one chapter of a good trader biographydaily. Within one year you will have read several biographies of peoplewho have won the war more than once. You will leverage their experienceinto your own.

Study Winning Traders 165


167

RULE #28

Be a Studentof Yourself

In the land of the blind, the one-eyed man is king.

—Old Yiddish saying

I think the hardest thing for most people to develop is a truly transpar-ent point of view about themselves. All of us have strengths and weak-nesses. We all have degrees of misconceptions about ourselves and the

world around us. We have character flaws and unique talents. We have allmade mistakes and we have all had successes. No matter how you slice it,every human being is an individual first before being part of a group. Thatindividuality is expressed differently by each person. The sum total ofthose individualities becomes our circle of influence, our friends andneighbors, our towns and governments, and ultimately part of the total hu-man experience—the history we participate in.

Within that moment-to-moment expression of our individuality as itbecomes our history, there is the corresponding potential that some ofus (as individuals) will choose to express the negative, dark side of ourpotentials. The individual who refuses to accept the responsibility tobehave reasonably becomes the criminal we have to incarcerate; thecircle of friends who all think in that criminal way becomes the streetgang we have to be protected from; the government more interested initself than in its people becomes the rogue nation that threatens every-one; and so on.

Each of our individual expressions, for better or worse, becomes thenever-ending cycle of group behavior, which in turn becomes economicgood times and bad, the daily pleasures and pains we have in life, laws we


have to follow, the times of war and peace—and, believe it or not: the cy-cle of bulls and bears. When the individuals form into a group, the group isat the mercy of the prevailing total of the individuals’ input. The market-place is unique because even though the market is a group and subject togroup behavior, each individual can participate at any time he or shechooses, while the total group goes on with or without that individual.Our individual participation helps create the group and we can exploit thegroup, but that is also an individual choice too.

In my opinion, the single biggest problem facing each of us as tradersis knowing where to draw the line in our individual thinking as it then be-comes our individual actions imposed on the group. We need to under-stand what creates our urge to action. Every one of us has a uniqueexpression of how we handle data input and what that means. For someof us, a sharp rally in a market stimulates our desire for a profit by focus-ing on the market getting “too high”; we might be looking for a short.Other traders will see that as a breakout and will jump on the market fromthe buy side. Some will do nothing and wait for a pullback to buy, or see apullback as a confirmation of a failed high before selling.

In all cases, the price action is simply there; it just is. All of those vari-ous ways of making a conclusion are unique to the individual. They comefrom inside of us and are solely determined by how we personally chooseto see things. Every trader participating in every market is choosing to seethings a certain way; they are all unique individuals using the markets as aform of expression for this conclusion-making process. We all execute ourtrades from a unique point of view. But in all cases, the price action itselfis the same for everybody. We as individuals form the conclusion as towhat it means. The group itself is impervious to this. The group just goeson, with or without us.

In your trader development you will sooner or later be faced with alosing trade that makes no sense to you. This is a factor of how you at-tached meaning to the price action that created your urge to action,your participation. The group had nothing to do with that evaluationand conclusion-making process. Once you join the group in progress,you are at the mercy of the group’s behavior as a sum total of everyother trader’s individual participation, too. If the trade you selected is aloser, that loser had nothing to do with how you came to the conclusionthat it was time to participate; it is a factor of everyone else’s participa-tion. Your choice came from inside you; your results came from insidethe group.

It is for this reason that your personal, unique individual expression ofyour conclusion-making process needs to become as transparent to youas you can make it. Unless your conclusion is of the sort that the grouppotential is in your favor, you have little or no chance for a gain once you

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execute and place yourself at risk. This transparency is something that isnot a natural state for most people, for the simple reason that our dailylives do not require it. You can go through life never once working on yourcharacter imperfections or your weaknesses and still have a very nice life,for all intents and purposes. It is usually only when our weaknesses orflaws become glaringly obvious that we are willing to address them, suchas an addiction problem. The world is full of horrible people who get onjust fine no matter how much destruction they create around them. Theworld is also full of wonderful people who get on just fine. Once we all de-cide to trade in the same markets, and create a group none of us has con-trol over, everything changes. The biggest idiot in the group can profit ifhe is on the right side of the net order flow, and the Nobel Prize winnerwill have a loss if he is on the wrong side. It’s as simple as that.

So why do we need to study ourselves? Because when we understandwhy we do what we do the way we do, we are no longer at the mercy ofthe group. Until our thinking and behavior is divorced from the group’sthinking and behavior, we cannot see the group’s thinking or behavior forwhat it really is. The crowd or group is behaving from its conclusion-mak-ing structure. That structure is called the herd. Until we can see clearlyhow a herd functions, we cannot know when to get out of the way of theherd or steer the herd.

We must rise above the average thinking process coming from an un-regenerate mind. We must study our own thinking and behavior to recog-nize when it is destructive or profitable. When we see the herd choosing tobehave destructively we have the opportunity to behave profitably. Be-cause the market is a crowd, a group, and a herd, it will never functionfrom anything except the sum total of the individuals’ behavior—and thatis always at the lower end of the spectrum as long as the group is made ofpeople who can’t see they are destructive. Most traders have net lossesbecause they think and behave very similarly to every other member ofthe group. When a trader chooses to think and behave differently, he is theonly one available for new information about the structure of the group.This difference comes from self-analyzing your thinking and dissectingyour behavior until you see clearly how you are performing exactly likethe crowd or in some other unique manner. Once you know this differ-ence, and it doesn’t have to be by a wide margin, you will finally buy weak-ness and sell strength often enough to win.

It is easy to say “Be a student of yourself,” but what are the practicalaspects of making a commitment to develop this skill of transparency?

No matter your personal state of development, you have to come tothe understanding that this process of developing transparency is aboutlifting the veil of illusion. The price of knowledge is the destruction of illu-sion. People who will not let go of their illusions are the ones who suffer

Be a Student of Yourself 169


the most. In the trading arena the illusions we operate under come to fullconfrontation very quickly. Some traders call this process forced aware-

ness. By this they mean that your personal conclusion-making process iswhat it is and when you have losses in your account you are wrong. If atrader excuses his loss in any manner, he is operating under illusion untilhis money is all gone. Now the trader has only one choice: Admit that hehas an illusion problem or deny it further. If the trader is truly on the path-way to transparency, the total loss in his account came from forcedawareness. The trader cannot deny that the results in his account are be-

cause of his actions alone. This is why self-study leading to self-aware-ness is so important. Without it you will experience forced awareness.Which do you prefer?

To avoid experiencing forced awareness, you can start the process ofconfronting your personal depth of illusion anytime. Most people do notlike what they see about themselves when they do, or will not accept theyreally have that particular issue. This is why an intervention can be so ef-fective when confronting people with addiction problems, because untilthat point, the addict really doesn’t think he has a problem. When con-fronted with a choice between the drug and the friendship, the die is cast.The responsibility is now with the addict. In trading, you must be both theproblem and the solution. You have to confront yourself or the market willdo it for you. It is a choice—keep the illusion or keep your money. Whichdo you want most?

To consistently confront myself, so that I reduce the amount of illu-sion I might be operating under, I have a stack of note cards with ques-tions written on them. I ask myself every day, “Am I hoping the marketwill go my way?” “Am I afraid to execute?” “Am I trusting something be-sides myself to earn a profit today?” or numerous other questions. I alsohave note cards with reminders on them such as “Wait for the market tohit the stops before executing,” “The market does not know my position,”“Follow your rules 100%,” and others as well. The point is that for me per-sonally I have found that my tendency to illusion is lessened if I remindmyself daily what the basics are and what the rules are. I no longer havethe conversations with myself or others that involve opinion about priceaction, what the fundamentals will do to prices, what some talking head inthe press has to say, and so on. I no longer think like the crowd, so I nowknow how to exploit that crowd thinking.

I have to do this daily because I also know I have a tendency to over-confidence. When I am winning consistently I am tempted to think I knowwhat I am doing. That is an illusion as well, and right about then I start los-ing. Since I am tired of losing and don’t want to do it any more, I am will-ing to do whatever it takes to remain a winner, even if that means my petillusions about myself end up in the trash can.

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Please understand, in this short description of this rule it is impossi-ble to give you a detailed pathway for developing transparency and avoid-ing forced awareness. Again, the Recommended Reading section includestitles that will provide you with great places to start this process of chang-ing your thinking enough to exploit the crowd. But there is no easy way.Always remember that every trader had to learn to trade. No one at thetop of his or her game got there by accident, and all successful traders willtell you that the first blowout taught them not to rely on illusion. It startedthem on the pathway to true understanding.

That understanding is that the market is created inside your ownhead. How you see things determines how you will trade. Learn to seethings in a new way. All the other rules are designed to keep you in thegame until you can see clearly how to out-think the crowd.

Be a Student of Yourself 171


173

Conclusion

Remember, the market doesn’t beat a player. It

merely gives him the chance to beat himself.

—The 1989 Commodity Trader’s Almanac

I really enjoyed writing this book. As I said in the Introduction, I tooktime to answer questions I hadn’t thought of before. In looking at thingsfrom a fresh perspective and attempting to write concisely, I rediscov-

ered old truths in a new way while becoming reacquainted with the basicsmore completely. I sincerely hope you have enjoyed reading and that youhave acquired at least one new concept you can apply to improve yourapproach. I know I have. But seeing as this is for you, let me offer you aconclusion.

Trading is not what people think it is. It is tempting to believe that suc-cessful speculation is a factor of economic fundamentals, political influ-ences, supply and demand, being in the right place at the right time, and alittle foresight, all rolled into one. We can convince ourselves that withenough study and enough knowledge, combined with enough persever-ance and some critical timing, we will find our fortune waiting on the otherside of our hard work like a pot of gold at the end of the rainbow. But thetruth of trading is more like the sirens calling over the waves, wooing us toa certain shipwreck if we aren’t careful.

As you put together your trading approach and look for your edge, Ithink this whole book can be summed up with the understanding that yoursuccess is not outside of you. Your success is inside of you. If you havebeen reading between the lines, you probably have come to the conclusionthat every trading rule is related to every other rule on some level. All ofthese rules that work have an underlying psychology that includes nonat-tachment to results, the recognition that anything can happen, and the un-derstanding that the crowd doesn’t know what it is doing. Since weoperate from a certain point of reference in order to create opportunitiesfrom the apparent randomness of price action, all we really need to do isremain vigilant enough to get out when we are losing and stay in when weare winning. The less energy we put into forming value judgments about

ccc_trading_173-178_conc.qxd 8/31/06 7:59 AM Page 173

prices, expecting the market to do one thing over another, or trying to fixwhat isn’t broken, and the faster we will admit we are wrong, the more po-tential for net gains we will have. When you think about the underlyingpsychology of that kind of behavior you come to the inescapable conclu-sion that we control our destiny as traders with more certainty than wecontrol the rest of our lives. When we realize that, our potential tradingwill truly be effortless and without inner conflict.

I think that most traders will admit that up to a certain point, or evencurrently, their trading has been frustrating, painful, irritating, or filledwith some other negative emotional conflict. All of what we surround our-selves with as part of our daily trading routine are often designed to helpminimize or eliminate this inner conflict. But almost all of what we feel asinner conflict has nothing to do with the market. We create that conflictfrom how we choose to view what is happening or from internalizing whatit all means for our trading balance. The market is just a machine process-ing orders. How can a machine create so much conflict in our daily lives?

The machine has nothing to do with the conflict. Stop and thinkabout how silly it is to get angry with your car if you run out of gas. Thecar told you very clearly it needed gas with that little flashing light nextto the “E” on the gas gauge. You created the conflict by ignoring the veryclear signals the car itself was giving you. You don’t have to experiencethe conflict; just stop and get gas. If that means you will be late for adate, then your problem is time management; that is not the car’s fault.For some people, trading is like driving with a broken gas gauge down adeserted country road between towns. They have no idea when the carwill quit, so every mile is a sense of impending doom. In trading, theproblem is not with the market (the machine) but in our failure to man-age ourselves.

The point of Trading Rules that Work is to free your mind from theconsequences of your emotional state. If you are still developing yourtrade approach, controls on your behavior will prevent you from exe-cuting bad trading behavior. Bad behavior will surely result in losses,and if those losses are complicated by severe negative emotions, yourmental energy is taken up with trying to eliminate pain instead of find-ing opportunity. That is exactly how the crowd is thinking; that is whyso many traders have net losses when they don’t have to. Can you imag-ine a road full of people tearing their hair out, yelling at their out-of-gascars, when there is a gas station at every intersection as far as the eyecan see?

Traders tend to complicate things needlessly when they add emo-tional pressure on top of basic pressures. Losses in the market are a factof life, and many are avoidable. But when you beat yourself up for the loss

174 CONCLUSION


and wonder ceaselessly if the loss could have been avoided, you addstress to a process that is stressful enough without your help. There is noneed for that. Take a step back and think.

To develop your full trading potential you need a different paradigmof thought. This doesn’t mean you have to change your entire world andlife view (although that helped me). All you really need to do is ask your-self really good questions and have the courage to answer those ques-tions honestly, without kidding or deluding yourself. All of the rulesdiscussed in this book are places to connect with that new paradigm.While you are altering your point of view to be more in line with thescope of market/crowd thinking and behavior, the controls on your be-havior prevent you from giving away all your capital. Change is notsomething that happens overnight anyway, so I think it is unreasonablefor any trader to think he will make money without some basic educa-tion. The rules you create and impose for yourself are like having a settime to go to class every day. You won’t get educated without going toclass, and you have to be at class on time. You won’t make money trad-ing until you learn what you need to know, and the rules insure you willbe in class. Once you have your education, you don’t have to go to class.Once you know how to trade, you can change and improve your rules ifyou choose to keep them.

Regardless of how you want to look at it, the problem and the solutionlies within you—not the market. Try to remain the sort of trader who fullyaccepts responsibility for his results. Remember that you choose to exe-cute. No matter what you use to gain enough confidence to pull the trig-ger, you and you alone make that choice. Your analysis, fear, greed, hope,and lack of knowledge are all parts of that decision-making process untilyou reach the point of full control of your actions. Having controls onyour behavior puts you in a place where your inner confidence can growwhile you develop better outer behavior. As you see that your behaviorcan be consistent and profitable, you gain confidence in what will workfor you. You learn to execute better, you accept your results no matterwhat they are, you discover your trading strengths, and your tradingweaknesses are addressed in a way that you can accept. Once you fullyaccept your responsibility and fully control your actions, trading becomeseffortless and pleasurable instead of frustrating and painful.

But all of that change happened inside you. The market is just themarket and would have been there with or without you while thosechanges were made. So in the final analysis, you created your opportu-nity—not the markets.

Before we close I want to give you a few particulars that will help youdevelop your personal rules from these 28 guidelines. First, your rules

Conclusion 175


have to be personal. They need to be from inside you. I suggest you use alot of “I,” “me,” and “my” in your rules. For example, don’t make the rule“Only risk 30 points on a trade.” Make the rule: “I only risk 30 points on myinitial trade.” When you personalize your rules they have a greater impacton your thinking. The rules are no longer just good ideas floating aroundout there; they are personal behaviors you do every day.

I also suggest that you write them inside quotation marks to makethem your words when you read them, and read them out loud so you canhear them in your own voice. Have you ever had the experience when youwere about to do something and you heard your mother’s voice insideyour head telling you not to do that? Whether or not you did the behaviorisn’t the point. I bet for certain you stopped and thought about it beforeyou did or did not do it.

Second, review your rules at least twice a day. I read my rules in themorning before I get to my desk and after I do my daily market study atthe end of the day. I am in the habit of opening my trading day and closingmy trading day with a review of my rules. Psychological studies haveshown that if you begin and end the day with a consistent positive rein-forcement you sleep better, and you also perform better the next day. Thatis probably why kids always want to be tucked into bed at night. Theyseem to have no problem getting up early . . .

Also, make a consistent time away from the trading desk to do yourmarket analysis. I find that when I am not staring at a computer screen Iam not tempted to reevaluate my trading in real-time. Following Rule #14is much easier if you are sitting somewhere away from the market doingyour analysis with a paper printout and a calculator. At the end of the day,I print out my charts and any relevant information or studies and lock my-self in one of the unused cubicles in my office. I find that when I am awayfrom the actual price action and totally alone without distraction, I can fo-cus a lot better. Often I have remembered something or made a decisionabout something that I would have missed if I was in the heat of battle.

Last, next to all the rules in Part II, I think Rule #21 is the most impor-tant rule to follow as a new trader while you are developing your ap-proach. Once you have settled on a risk-control strategy to cut losses, thenext thing is to block out everything and think on your own. Of course,you need market research and commentary, but it is the way you use it

that will make all the difference. Rather than accept at face value whatyou read and hear, ask good questions about what traders would betempted to do with that data. Sooner or later all market data creates anurge to action, which results in a trade creating pressure on the orderflow. Ask yourself, “What have traders done already with this data?” or“What will other traders think this means?” When people around you offermarket commentary, politely excuse yourself or tell them outright to shut

176 CONCLUSION


up. The single best way to get a tipster to stay away is to ask him to showyou his account balance. In my opinion, nothing will slow you down fasterthan failing to follow Rule #21.

Other than these few thoughts, the floor is open. Every reader willhave a different way of enforcing these 28 guidelines. I would love to hearhow you personally have been able to apply what you are learning. Feelfree to drop me a line in care of Wiley; they will see that I get it. Also, read-ers are welcome to join me for my regular daily Internet broadcasts. De-tails are at my web site, www.proedgefx.com. Thanks for reading.

Conclusion 177


179

Recommended Reading

There is no end to the discussion of things. Endless

devotion to books and the study of opinion is tire-

some and wearying to the mind.

—King Solomon, Ecclesiastes 12:12

Ihave read hundreds of books relating to the markets, trading, and psy-chology. At one time my library of related material was larger thanmost people’s total libraries combined. I also had piles of newspapers,

trade magazines, audio/videotape series, and general notes from seminarsI attended. Once I reached a certain point in my education as a trader, I de-cided that most of it was all saying the same basic thing with usually oneor two fine points that really mattered. I took the point of view that what-ever I had spent in dollars was an investment into my trading skill, and aslong as I learned one thing that helped me add one more winning trade orprevent one more losing trade, this was all money well spent.

After a certain point I found myself focusing on a few books that Ifelt were the important ones. That is not to say that the other data I hadcollected wasn’t useful. It’s just that there is virtually an unlimitedamount of data you could expose yourself to if you wanted to, espe-cially with the available Internet resources, not to mention the huge in-vestment you could make of both time and money. At some point youneed to narrow your focus—otherwise you could find yourself spendingmore time studying than trading, and more money on education ratherthan trade capital.

I felt it was time to clean house. I threw out or gave away hugeamounts of market-related data but decided to keep what I felt were theessential needed things. I now have a much smaller library and also don’tbuy as much new stuff. As I wrote in Rule #27, I still invest a certainamount of time and money in continuing education, but it is a lot less andmore focused now. I think that as a trader you can gain a lot from thispoint of view because it will help you spend less time and money by notacquiring the same basic information compiled into another format. Youcan also benefit because your learning curve may be shortened.

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The books listed in this section are the ones that I feel cover the es-sential elements to developing a winning trade approach and creatingtrading rules that will work for you. I think it is important to reiterate thatall the rules you choose to use for yourself are self-created and self-im-posed. The reason I feel these books cover the basics well is because theyall have a common theme. All of these books start from the premise thatthe trader himself is the most critical component to lasting success. All ofthe building blocks discussed that are market related, such as technicalindicators and so forth, usually are covered in deep enough detail thatvery little more can be added to the discussion. Also, most of the psychol-ogy discussed as it relates to rule making, trading approaches, moneymanagement, and so on, continues to support the point of view that the in-dividual needs to become fully in control of his actions when he trades.We can’t control the market; we can only control ourselves.

Some of the books are not market related at all, but I included thembecause I feel they expose the crowd thinking/behavior connection well.The books are listed in alphabetical order by author—no special endorse-ment for any one book or author is intended. I include a brief descriptionof why I like each one. And finally, no compensation was given to me toselect these books. I genuinely feel the author and the subject are valuableenough to include them in the list.

Abell, Howard, and Robert Koppell. The Inner Game of Trading. Chicago: ProbusPublishing, 1994. Focuses on the relationship between thought and action. Helpsclarify the difference between intents and desires.

Carret, Philip L. The Art of Speculation. Burlington, VT: Fraser Publishing Com-pany, 1930. Great book on tactics, several useful methods for effective positioning,lots on equities.

Douglas, Mark. The Disciplined Trader. New York: New York Institute of Finance,1990. Critical discussion of zero-sum psychology. Lots on staying focused on yourmethod.

Douglas, Mark. Trading in the Zone. New York: Prentice Hall, 2000. More on thedaily discipline to your method, seeing trading as a holistic experience.

Koppel, Robert. The Tao of Trading. Chicago: Dearborn Financial Publishing,1998. Point of view includes focus and understanding regarding consistency. Howworld and life view affects execution.

Le Bon, Gustave. The Crowd: A Study of the Popular Mind. Atlanta: CherokeePublishing Company, 1895. (Reprinted by Fraser Publishing Co., 1982) Early workon defining the factors that contribute to and disclose crowd behavior.

Lefèvre, Edwin. Reminiscences of a Stock Operator. Burlington, VT: Fraser Pub-lishing Company, 1928. (Reprinted by John Wiley & Sons, 2006.) Autobiography ofJesse Livermore. In my view the best all-around work on what makes or breaksthe trader. A must-have in any trader’s library.

180 RECOMMENDED READING


Longstreet, Roy W. Viewpoints of a Commodity Trader. Greenville, SC: Trader’sPress, 1967. Lots of small one- or two-page thoughts on maintaining a strong mar-ket presence. Great for keeping thoughts and emotions balanced.

Mackay, Charles. Extraordinary Popular Delusions and the Madness of Crowds.New York: Harmony Books, 1841. (Reprinted by Three Rivers Press, 1995.) Excel-lent historical documentation of failed beliefs, manias, panics, and eccentric be-havior accepted as current scientific truths.

Millman, Gregory J. The Vandals’ Crown. New York: The Free Press, 1995. Historyof the rise of FOREX trading. Documents the failure of governments to accountfor or control currency pricing.

Neill, Humphrey Bancroft. The Art of Contrary Thinking. Greenville, NC: TradersPress, 1954. Definitive book on thinking outside the box.

Rogers, Jim. Hot Commodities. New York: Random House, 2004. Current mega-trends on consumables. Will be out of date someday but still outlines great long-term potential in current markets plus thoughts on how to find great long-termtrades.

Schwager, Jack D. Market Wizards. New York: New York Institute of Finance,1987. Interviews with top traders from all markets. Timeless.

Schwager, Jack D. The New Market Wizards. New York: HarperCollins, 1992. Up-dated interviews with more top traders, new focus on trading styles.

Shaleen, Kenneth. Volume and Open Interest. Chicago: Probus Publishing, 1991.Critical study on market structure, how crowd behavior can be disclosed by V/OI,effective tools for identifying potential trend changes.

Sperandeo, Victor. Methods of a Wall Street Master. Canton, NJ: John Wiley &Sons, 1991. Great all-around work on trader discipline. Trader Vic is completelyhonest and very well-thought-out discussions are provided.

Tolle, Eckhart. The Power of Now. Novato, CA: New World Library, 1997. Tolle’sexperience with enlightenment. How the Western mind defeats itself (in all en-deavors) and what will make a critical difference.

X, Trader. Dancing With Lions. Ashland, OH: Bookmasters, 1999. Autobiogra-phy—author focuses on detachment and the power of conviction. Detailed discus-sion on trader evolution, some basic trade methods also.

Recommended Reading 181


183

About the Author

Jason Alan Jankovsky is a full-time trader working from downtownChicago. He began his career as a Series III Commodities Broker inMay 1987 after trading as an independent customer for more than a

year prior. During the intervening years he has been involved in almost allfacets of the futures industry and also the cash FOREX markets. Currentlyhe works on behalf of public traders as an educator for the customergroup of Infinity Brokerage Services and their sister company ProEdgeFX,both headquartered in downtown Chicago. In addition to broadcasting livea twice-daily foreign exchange commentary, he contributes to several reg-ular online publications, is a regular commentator on FOREXTV.com, andteaches the “Psychology of Trading” course for traders around the globe.He is a private pilot and avid sailor.

Details of Mr. Jankovsky’s broadcasts can be found at www.proedgefx.com. He can be reached directly at Infinity Brokerage at 1-800-531-2817 or by e-mail at [email protected].

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185

Abell, Howard, 131Actual behavior, trading and, 61Actual opportunities, 53Actual performance, 111, 112, 115Actual prices, 107Actual risk, 107Actual time frame, 25Actual time price pattern, 71“Add to your winners” rule, 65–69“All markets are bearish” rule,

143–148“Always place a protective stop”

rule, 37–41Attachment trade:

emotional, 49overtrading and, 54price and, 44–45

Back-tested market, 65–66Baseline of behavior, overtrading

and, 54Basic market structure, 144“Be a contrarian” rule, 137–141Bearish trader, time frame and, 26Bear market:

in FOREX, 101prices and, 43–44

“Be a student of yourself” rule,167–171

Behavior, crowd, 137–139“Black box” traders, 157Bona fide hedger, 146Breakout approach, 98Break taking, 117–121Bull market:

coming to conclusion in, 144 equities in, 100–101exploitation by professional

selling, 147in FOREX, 101prices and, 17–19, 18f, 43–44selling and buying hedgers in,

148Buy orders, 4–5, 6, 19, 19f

“Buy/sell 50% retracements” rule,66, 149–154, 152f

Buy side, executing from, 73“Buy the rumor, sell the fact” rule,

123, 125

Cash trading balance, 34–35, 49CCI. See Commodity channel index

(CCI)CFTC. See Commodity Futures

Trading Commission (CFTC)

Change to the structure of themarket, 158–159

Index

Page numbers followed by f indicate a figure.

ccc_trading_185-192_ind.qxd 8/31/06 8:01 AM Page 185

Character, trading time frame and,24

Chart Your Way to Stock Market

Profits (Markestein), 91Chicago Board of Trade, 92, 131,

155Clason, George S., 133Clemens, Samuel (Mark Twain),

155, 159“Clock time,” 71, 74Close strategy, 67“Commitment of Traders” report

(CFTC), 147Commodity channel index (CCI),

92Commodity Futures Trading

Commission (CFTC), 147Communication, traders and, 52Conclusion-making process,

168–169, 170Confidence, profit objective and,

79“Congestion” price, 38“Consolidating” price, 38, 66Consumer price index (CPI),

33Contrary thinking, 137–141Control, loss of, 32Corn market, 145–146CPI. See Consumer price index

(CPI)Critical deduction, process of,

95Crowd behavior, 137–139Crude oil trading, 106–107Currency markets, 101Current trend, end of, 97–98Cutting losses:

defining risk and, 34key to, 52selecting time frame and, 28traders and, 31trading system and, 11

Daily price chart, 73Daily time frame, 27Data gathering, 61Declining market, 139“Define your risk” rule, 31–35Documenting thoughts and

emotions, 62“Don’t give tips,” 132“Don’t overtrade” rule, 51–55“Don’t second-guess your winners”

rule, 83–87“Don’t take tips” rule, 129–132“Don’t trade the news” rule,

123–127Double-top formation, 72Downtrend:

end of, 103trading in, 5, 101–102typical chart, 98, 99f

Drawdown point, 65–66, 69

Educational process:prioritization of, 33risk-reduction strategy and,

161–163Elliot Wave analysis, 150–151, 153Emotional attachment, 47Emotional needs:

traders and, 48–50trading plans and, 12

Emotions, documenting, 62End of downtrend, 103End of trend, 97End of uptrend, 103Equity(ies), 144

in bull markets, 100–101withdrawing, 133–136

Execution system, 54Exit orders, 78

Family input, trading and, 33–34Fibonacci, 150, 151, 153Fibonacci Progression, 150

186 INDEX


50% ratio, 150–151Financial freedom, 136Financial risk, trading plan and, 12Forced awareness, 170Forced liquidation matrix, 146f

FOREX, 33, 10142% winning trades, 112–114Fundamentals and prices,

relationship between, 125Funds, risk and, 35Future contracts, 155

Gann, W. D., 150–151, 153, 154

“Have a trading plan” rule, 9–14Hedgers:

bona fide, 146goal of, 107–108markets and, 147–148selling pressure of, 145–146speculators and, 147

Herd, 169Hourly time frame price chart,

72Hourly time frame trader, 26Hunt Brothers, 129

Improper equity allocation, 105Industrial Revolution, 155Information:

access to, 53database, creating, 60–61overload, 161

Inner data gathering, 61–62Inside information concept, 156Interest rate traders, 33Intuition, 95

“Keep good records and reviewthem” rule, 59–63

Knowledge, 95, 143“Know the limits of your analysis”

rule, 91–95

“Know when to take a break” rule,117–121

“Know your game” rule, 3–7“Know your profit objective” rule,

77–81“Know your ratios” rule, 111–115“Know your time frame” rule,

23–28

Lane, George, 92Limit orders, 5Liquidating:

to exit market, 49stops, 37

Liquidation, net order flow and, 109

Liquid market, 27Livermore, Jesse L., 153Long position, 4, 67Long-term success, 100Long-time-frame price chart, 71Long time frames, 24, 72Long vs. short time frame, 24Losing longs, 146Losing trade, 4, 49Loss:

of control, personal psychologyand, 32

over time, 47–50stop-loss orders and, 36–37trading and, 43–46

MACD. See Moving averageconvergence divergence(MACD)

Margin, 106Market(s):

analysis of, 176basics of, 138breaking out to the upside, 67change to the structure of,

158–159currency, 101

Index 187


Market(s) (Continued)

dynamic conditions of, 67–68executing into, 49hedgers and, 147–148liquid, 27overextended, 156–157overtrading and, 52, 53–54quality of, 65–66strong and weak, 139strong presence in, 134structure, basic, 144

Markstein, David L., 91Momentum identifiers approach,

98Money management, effective,

105–109Morgan, J. P., 7Movable stops, 39–41Moving average convergence

divergence (MACD), 54, 91,130

Multiple executions (overtrading),54

Multiple time frames, using, 71–75

“Natural time frame,” 23, 25Net losing traders, 9, 51Net order flow. See also Order

flowanticipating, 79apparent, 67–68change of, 95creation of, 139depth of, 66identifying, 39liquidation and, 109losing position and, 125loss and, 47multiple time frames and, 38,

72–74Net winning traders, 9, 134–135,

138“Never add to a loser” rule, 47–50

News, trading, 123–127Nonattachment to markets, 134,

136Nonattachment to trade, prices

and, 44

OHLC price bars. See “open-high-low-close” (OHLC) price bars

One trend, end of, 97Open-ended questions, trading and,

20–21“Open-high-low-close” (OHLC)

price bars, 71Open interest, 68Open short, 5Open-trade long, 5Open-trade loss, 5, 93Open-trade profit, 5, 38, 66, 73Opportunities:

perceived and actual, 53trade, 7

Orange juice crop, 124–125Order flow, 7. See also Net order

flowimbalance of, 4, 5, 48losing and winning side, 46losing trade and, 31–32

Oscillators and indicators, 156–157Other people’s money concept,

106Overbought concept, 156–157Overextended market, 156–157Oversold concept, 156–157Overtrading, 47, 51–55

Pennant formation, 72Perceived opportunities, 53Perception:

price action and, 5, 6regarding certainties and

probabilities, 16–17Performance, improving, 117–121Performers, top, 119

188 INDEX


Personal discipline, redefininglosing trade and, 49

Personal experience of trading,118–119

Personal financial conditionassessment, risk and, 33

Personal psychology, traders and,3, 6, 32

“Placing a stop-loss order,” 37PPI. See Producer price index

(PPI)Predetermined exit points, use of,

37–39Price action, 38

flow of, 5perception and, 5, 6phenomena of, 123predicting, 94–95psychology behind, 4strong, 80, 139weak, 139

Price charts, 71–73Prices:

actual, 107advance and decline of, 6attachment trade and, 44–45bull market and, 17–19, 18f,

43–44fundamentals and, 125market orders and, 5potential, 107significant, 152and time, 150

Price/time relationship, 66–67, 137Probabilities, trading and, 15–21Probability of ruin matrix, 112–114,

113f

Producer price index (PPI), 33Profit management tools, 37–41Profits:

letting profits running, 60–61locking, 108objectives, success and, 77–81

trade and, 16–17in zero-sum markets, 6

Protective stops, 108Psychology:

behind “don’t second-guess yourwinners,” 85–86

behind “don’t take tips,” 131behind “don’t trade the news,”

123–127behind “letting profits run,”

134behind price action, 4behind “trade with the trend,”

100behind “using effective money

management,” 109market, 3of traders, 3, 6, 32

“Psychology of Trading” seminar,92, 111

Pullbacks, 108, 126, 140Pyramiding loss, 48–49

Range, 98, 99f, 100, 102, 103Ratios:

actual performance and, 111,112, 115

calculation of, 112Record keeping and reviewing,

59–63, 112, 114Resting order, 78Retracement analysis, 150–151Reverse strategy, 67Review of rules, 176Richest Man in Babylon (Clason),

133“Right now” trade, 25, 26, 27, 44Risk:

actual, 107balance and, 109defining, 31–35financial, trading plan and,

12

Index 189


Risk (Continued)

hedgers and, 107perception of, 108trading markets and, 17–18wealthy individuals and, 106

Risk/reward ratio, 78, 97Rolling stops, 40Ruin matrix, probability of,

112–114, 113f

Rules, review of, 176

Self-awareness of methodology,trading and, 45

Sell orders, 4–5, 672-hour rule, 150, 151–152, 153, 157Short position, 4Short-selling, 101Short time frame, 24, 27–28, 72,

75Short-time-frame price chart, 71Significant price, 152Silver market, 129–13060% winning trades, 113Size of trade, 135Speculators:

corn market and, 145–146market opportunities and,

155relationship of hedgers and,

147Stop-loss buying, 79Stop-loss orders, 10, 37–39

movable, 39–41Stop orders, 4–5Stops:

liquidating, 37movable, 39–41placing, 38–39rolling, 40

Strong market, 139“Study winning traders” rule,

161–165

Subjective experience of trading,118–119

Success:information and, 114long-term, 100profit objectives and, 77–81reducing participation method

and, 12–13traders’ personal psychology

and, 3in trading, 173–174without analysis, 156“your first loss is your best loss”

rule and, 43–46Systematic trading approach, 62, 69

Technical analysis, 93–95successful, 156

“The only indicator you need” rule,155–159

“Think in terms of probabilities”rule, 15–21

Thoughts documentation, 62Three-to-one reward-to-risk ratio,

78, 79Time frame. See Trading time

frameTime/price relationship, 107, 150,

153, 158–159Tips taking, 129–132, 176Top performers, 119Trade:

entering, 17losing, 49selection, 20, 45size of, 135winning, creating, 60

Traders. See also Speculatorsattachment, nonattachment

trade, and, 44behavior of, 138“black box,” 157

190 INDEX


communication and, 52defining risk, 31–35emotional need of, 48–49hourly or weekly, 26–28market information and, 51–52,

53net losing, 9net winning, 9, 134–135, 138reading the crowd, 140trading opportunity and, 3–7trading plan and, 9–11using “don’t second-guess

your winners” rule,86–87

winning, 161–165“Trade with the trend” rule,

97–104Trading:

actual behavior and, 61approach, systematic, 62defining risk of loss and,

32downtrend, 101–102experience of, 118–119funds, 34–35gathering hard data in, 61loss and, 43–46markets, structure of, 3–4the news, 123–127probabilities and, 15–21profit objectives and, 77–81range, 102sensitivity to personal side of,

34uptrend, 100–101using predetermined exit points

in, 37–41vs. trading systems, 162–163zero-sum, 4

Trading breaks, trading plan and,12

Trading edge, 156

Trading plan:creating, 11–14example of, 13–14vs. trading system, 9–11

Trading process, self-awareness in,45

Trading systems, 9, 10–11vs. trading, 162–163

Trading time frame:actual, 25best trades and, 27character and, 24finding congruency in, 25–26multiple, 71–75“natural time frame,” 23,

25selecting, 24, 26–28shorter and longer, 24

Trend:clearly appraising, 102–104,

103f

definition of, 97–98, 100followers, 98

Trend-following strategy, 12, 66Turnover, 692:1 profit/loss ratio, 115

Upside break out of the market, 67Uptrend, 5

range at the end of, 103trading, 100–101typical chart, 98, 98f

“Use effective moneymanagement” rule, 105–109

“Use multiple time frames” rule,71–75

V/OI. See volume and open interest(V/OI)

Volume, rise in, 69Volume and open interest (V/OI),

19–20, 158–159

Index 191


Weekly price chart, 73Weekly time frame trader, 25–26,

27Williams %R, 91Win/loss ratio, 65–66Winning approach, developing,

149–150Winning shorts, 146Winning traders, 161–165

net, 9, 134–135, 138Winning trades, 4, 65–59,

112–114

“Withdraw equity regularly” rule, 133–136

Worst-case exit order, stop-lossorders as, 40

“Your first loss is your best loss”rule, 43–46

Zero-sum markets, 4, 6, 101,144–145

Zero-sum transaction trading, 4,92–93

192 INDEX
